## EXECUTIVE SUMMARY ## Source details **Canonical URL:** [EXECUTIVE SUMMARY](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16192.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16192.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16192.pdf.json) --- ### Introduction and Scope - Technical note prepared as part of the 2015 Financial Sector Assessment Program (FSAP). - Drawn on discussions in Germany from November 3 to 18, 2015. - Refers to Insurance Core Principles (ICPs) issued by the IAIS in October 2011, as revised in October 2013. - Focus areas: low interest rate pressures (especially life insurance), implementation of Solvency II (took effect in full on January 1, 2016), and supervision of large insurance groups including G-SIIs. - Includes analysis of selected ICPs with macrofinancial relevance (valuation, investment, capital adequacy, supervisory approach, cross-border co-operation); detailed ICP analysis set out in the Annex. ### Key risks and sectoral vulnerabilities - Low interest rate environment - Prolonged low rates eroding insurers’ ability to provide expected returns and potentially to meet guarantee commitments over the medium term, most acutely in life insurance. - Health, property and casualty (P&C) and reinsurance companies affected to a more limited extent due to lower dependence on investment returns. - Underwriting cycle and downward pressure on reinsurance rates managed through changes in business mix and active repricing. - Financial strain - Many life insurers have built considerable financial strength and performance remains sound, but prolonged low rates could cause strain at individual companies, particularly those concentrated in traditional life lines. - Multiple measures of financial strength - Solvency II reporting (with and without adjustments/transitional measures) and national GAAP both relevant, creating potential uncertainty and complexity in interpretation. - National GAAP remains central to policyholder participation provisions in German life insurance, complicating Solvency II implementation. ### Solvency II implementation and transitional measures - Solvency II requires forward-looking recognition of future costs, increasing current valuation of commitments for insurers subject to its requirements (most insurers). - Germany-specific measures and history - Since 2011 life insurers required to build increased reserves via the Additional Interest Provisions (Zinszusatzreserve or ZZR). - Legislative changes in the 2014 Life Insurance Reform Act provided relief on distribution of unrealized investment gains to departing policyholders. - Adjustment measures for Long-Term Guarantees (LTG) and transitional measures phasing in new requirements over 16 years have been offered in full, subject to BaFin approval. - Reporting and valuation landscape - Solvency II numbers will be reported with and without adjustments and transitional measures (supervisory reporting from 2016; public disclosure requirements from 2017). - Financial statements will continue to be based on national GAAP, which has not been aligned with Solvency II. ### Regulatory and supervisory capacity and approach - BaFin - Principal insurance supervisor; part of executive branch, responsible to the Federal Parliament via the Federal Ministry of Finance (BMF). - Supervisory framework based on the Insurance Supervision Act (VAG). - Strengthening under Solvency II - Supervision has become more risk-based with increased focus on groups and group reporting. - Internal model approval process built technical expertise; BaFin’s insurance supervisory resources increased substantially and appear appropriate for new demands. - Supervisory approach and challenges - Solvency II’s principles-based governance, risk management, and investment rules allow considerable use of own assumptions by insurers, increasing supervisory judgment demands. - Some aspects of BaFin’s approach remain relatively compliance-based; scope exists to shift focus to qualitative requirements and peer group review. - Retraining of supervisors and rethinking supervisory processes are under way and need to continue. ### Supervision of groups and G-SII framework - BaFin implementing IAIS framework for G-SIIs where it has responsibilities. - Further development needed to implement IAIS proposals on additional loss-absorbing capacity; no single EU framework exists for this presently. - Scope exists to apply BaFin’s requirements on the one German domestic G-SII to other large groups that include reinsurance with global reach. - BaFin could consider applying macroprudential tools used for primary insurers (regular stress tests, recovery and resolution planning) to reinsurers. ### Market structure, products and industry performance (key statistics) - Number of insurers and assets - 413 insurance companies supervised by BaFin; 139 small mutual companies. - Total investments of insurers in 2014: EUR 1,569 billion. - life insurers: EUR 911 billion, - health: EUR 232 billion, - P&C: EUR 154 billion, - reinsurers: EUR 272 billion. - Total assets of the banks: EUR 8,315 billion. - Number of insurers declined from 460 (2008) to 413. - Profitability and solvency - Average ROEs in the last three years: - life: 6.6 percent, - P&C: 4.0 percent, - reinsurers: 8.3 percent. - Average solvency ratios at end-2014: - life insurers: 163 percent, - P&C: 312 percent, - reinsurers: 885 percent. - Investment profile (life insurers, ratios against total assets) - government securities: 25 percent, - mortgage bonds: 21 percent, - bonds of financial institutions: 11 percent, - equity: 6 percent, - alternative investments: 1 percent, - mortgage loans: 6 percent, - other loans: 6 percent, - real estate: 4 percent. - Product composition - Products with minimum guarantees dominate German life market; unit-linked and related products account for less than 10 percent of total liabilities of life insurers. - Unit-linked products account for about 15 percent of total premium income in the last five years. - Distribution channels - single-tied agents: more than 40 percent in life and P&C, 50 percent in health insurance, - bancassurance: less than 20 percent of the market even in life sales. ### Search for yield and asset risks (evidence) - Corporate bond share in life insurers’ total investments increased from 4.3 percent in 2011 to 6.9 percent in 2014. - AAA-rated securities portion fell from 44.8 percent to 35.6 percent between 2011 and 2013. - BBB-rated securities share rose from 7.1 percent to 12.8 percent between 2011 and 2013. - Increased investment in non-German sovereign bonds: Italian government bonds increased by 5 percent and Spanish government bonds by 25 percent from 2013 to 2014. - Investment in funds (end-2013) - allocated 23 percent of assets to bond funds and 3 percent to equity funds. - Total investment in funds now exceeds over 30 percent of their assets. - Funds which cannot be looked through account for less than 2 percent of total assets. ### Guarantee exposures, ZZR and liability duration - Guarantees on long-term life policies significant; average guarantee rate reduced to 3 percent. - Maximum valuation interest rate for new contracts reduced to 1.25 percent as of January 1, 2015. - Zinszusatzreserve (ZZR) - Reserve equals interest rate shortfall expected over the next 15 years; reference rate is the 10-year average of the zero-coupon euro swap rates with a duration of 10 years. - In 2014, EUR 8.4 billion was added to ZZR, resulting in over EUR 20 billion cumulative at year-end 2014. - If reference rate keeps falling, additional ZZR will be needed; insurers expected to be required to continue to add to the reserve by more than EUR 10 billion annually from 2016, with cumulative reserves reaching over EUR 70 billion in 2018. - Majority of allocations to ZZR appear financed by realizing previously unrecognized gains; some insurers conducting costly transactions to generate gains to meet ZZR requirements. - Duration of liabilities of German life insurers could be estimated as approximately 11 years. - Effective investment spread (internal measures from 2014 EIOPA stress test) had already turned negative (-0.4 percent). ### Solvency II surveys and impact assessment - BaFin surveys (balance sheets at December 31, 2013; updated to end-2014) - Initial survey: a few insurers with collective market share of less than 1 percent unable to show they could meet new requirements despite applying transitional measures. - Without transitional measures, about 25 percent of insurers, with a collective market share of about 10 percent, would not meet the SCR as of December 31, 2013. - Second survey (end-2014 positions): number unable to show they could meet SCR had not increased, but almost half of all insurers were dependent on use of transitional measures to meet their SCR and would have had a collective shortfall of some EUR 12 billion in own funds (compared with some EUR 60 billion in total life sector own funds). ### Long-term guarantee measures and transitional arrangements - Measures include: - Matching adjustment (permanent) — supervisory approval required and conditions applied. - Volatility adjustment (permanent) — set by EIOPA to avoid pro-cyclical investment behavior. - 16 years transitional arrangement — allows use of discount rates applying in December 2015 for contracts concluded before January 2016, phased out linearly to zero by end-2032. - Disclosure and supervisory constraints - Insurers using matching adjustment, volatility adjustment and transitional arrangements must disclose Solvency II figures with and without these measures. - BaFin introduced an additional measure to limit the transitional benefit so Solvency II requirements (with this arrangement) are more conservative than insolvency measured by national GAAP. - German life insurers most likely to use the volatility adjustment; matching adjustment conditions likely hard for them to meet. ### Supervisory review, resources and processes - BaFin’s preparatory work - Established standardized status reports, divided preparatory work into 15 thematic blocks. - Central quantitative unit grew to 18 staff (from 13 in 2010); Insurance and Pension Fund supervision employed 349 staff as at November 2015 (compared with 266 in 2010). - On-site evaluation of internal models and extensive on-site work for model validation. - Supervisory posture - BaFin maintains a watchlist of companies that may not meet Solvency II SCR and is in ongoing discussions with such insurers. - Intensive supervisory approach required during initial live reporting and future market volatility. - Recommendations on supervisory focus - Shift supervisory priorities after full Solvency II implementation from internal models to assumptions used by insurers on the standardized approach and on investments. - Maintain supervisory and specialist resources at their current high level to manage ongoing Solvency II implementation challenges. - Improve communication to insurers, particularly larger companies, on BaFin’s key concerns and supervisory priorities. ### Resolution, guarantee schemes and insolvency - Insurance guarantee schemes - Protektor (life insurance) and Medicator (private health substitutive). - Protektor financed ex ante; fund around EUR 897 million (1 per mille of net technical provisions of all members); additional special contributions up to EUR 863 million can be levied. - Life insurers committed under private arrangements to raising a total of 1 percent of net technical provisions (around EUR 9.0 billion). - Medicator funded on an ex post basis; a maximum of 2 per mille of members’ net technical provisions may be raised (EUR 388 million). - BaFin powers in impending insolvency - BaFin must order transfer of entire portfolio to guarantee scheme if insurer is a member (VAG2016 s222). - BaFin can temporarily prohibit payments, reduce life insurer liabilities, and otherwise act to preserve insureds’ interests. - Recommendation: review whether procedures to effect transfers of insurance portfolios to guarantee schemes allow for more complex portfolios readily to be transferred; consider power to require portfolio transfer to another willing insurer. ### Main recommendations (high-level) - Continue monitoring companies likely to face strain and maintain a watchlist; require and enforce appropriate action plans where necessary. Priority: High. - Ensure companies using transitional measures have robust and credible plans to meet SCR requirements by the end of the 16 years period and, where possible, earlier; include stress testing to ensure SCR resilience after plausible shocks. Priority: High. - Keep the calibration of the ZZR requirement under review within a framework of close attention to national GAAP given its continuing importance to regulatory objectives and fair treatment of policyholders. Priority: Medium. - Shift supervisory priorities after full Solvency II implementation from internal models to assumptions used by insurers on the standardized approach and on investments. Priority: Medium. - Maintain supervisory and specialist resources at their current high level to manage ongoing Solvency II implementation challenges. Priority: Medium. - Plan proactively to ensure a high degree of public understanding of the different Solvency II measures and the multiplicity and transparency of solvency numbers (noting public disclosure requirements from 2017). Priority: High. - Improve communication to insurers, particularly larger companies, on BaFin’s key concerns and supervisory priorities (for example by disclosing more findings from the risk classification system). Priority: Medium. - Consider a more formal intervention approach in case of deterioration under national GAAP measures. Priority: High. - Consider a more systematic approach to communicate supervisory expectations based on ORSA review; make full use of supervisory legislation to require capital add-ons where envisaged in Solvency II. Priority: Medium. - Consider applying macroprudential tools used for the German G-SII to all larger groups (regular stress tests; recovery and resolution planning). Priority: Medium. - Empower BaFin to place additional regulatory requirements on G-SIIs, including requirements for additional loss-absorbing capacity being developed by the IAIS. Priority: Medium. *Source: IMF technical note — EXECUTIVE SUMMARY (German insurance sector), drawn on FSAP discussions in Germany, November 3–18, 2015.* ### EXECUTIVE SUMMARY _____________________________________________________________________________ 4 ### EXECUTIVE SUMMARY ### Introduction and Scope - Technical note prepared as part of the 2015 Financial Sector Assessment Program (FSAP). - Drawn on discussions in Germany from November 3 to 18, 2015. - Refers to Insurance Core Principles (ICPs) issued by the IAIS in October 2011, as revised in October 2013. - Focus areas: low interest rate pressures (especially life insurance), implementation of Solvency II (took effect in full on January 1, 2016), and supervision of large insurance groups including G-SIIs. - Includes analysis of selected ICPs with macrofinancial relevance (valuation, investment, capital adequacy, supervisory approach, cross-border co-operation); detailed ICP analysis set out in the Annex. ### Key Risks and Sectoral Vulnerabilities - Low interest rate environment: - Prolonged low rates are eroding insurers’ ability to provide expected returns and potentially to meet guarantee commitments over the medium term, most acutely in life insurance. - Health, property and casualty (P&C) and reinsurance companies are affected to a more limited extent due to lower dependence on investment returns. - Other risks include the underwriting cycle and downward pressure on reinsurance rates; these are being managed through changes in business mix and active repricing. - Financial strain: - Many life insurers have built considerable financial strength and performance remains sound, but prolonged low rates could cause strain at individual companies, particularly those concentrated in traditional life lines. - Multiple measures of financial strength: - Solvency II reporting (with and without adjustments/transitional measures) and national GAAP will both be relevant, creating potential uncertainty and complexity in interpretation. - National GAAP remains central to policyholder participation provisions in German life insurance, complicating Solvency II implementation. ### Solvency II Implementation and Transitional Measures - Solvency II requires forward-looking recognition of future costs, increasing current valuation of commitments for insurers subject to its requirements (most insurers). - Germany-specific measures and history: - Since 2011, life insurers have been required to build increased reserves via the Additional Interest Provisions (Zinszusatzreserve or ZZR). - Legislative changes in the 2014 Life Insurance Reform Act provided relief on distribution of unrealized investment gains to departing policyholders. - Adjustment measures for Long-Term Guarantees (LTG) and transitional measures phasing in new requirements over 16 years have been offered in full, subject to BaFin approval. These measures defer full impact of market-consistent valuation on past business. - Reporting and valuation landscape: - Solvency II numbers will be reported with and without adjustments and transitional measures (supervisory reporting from 2016; public disclosure requirements from 2017). - Financial statements will continue to be based on national GAAP, which has not been aligned with Solvency II. ### Regulatory and Supervisory Capacity and Approach - BaFin: - Principal insurance supervisor; part of executive branch, responsible to the Federal Parliament via the Federal Ministry of Finance (BMF). - Supervisory framework based on the Insurance Supervision Act (VAG). - Federal State authorities and Chambers of Industry and Commerce (IHK) have limited supervisory roles for small/publicly-owned insurers and intermediaries respectively. - Strengthening under Solvency II: - Supervision has become more risk-based with increased focus on groups and group reporting. - Internal model approval process has built technical expertise and experience in international colleges of supervisors, although fewer groups applied in Germany than in some other EU countries. - BaFin’s insurance supervisory resources increased substantially in recent years and appear appropriate for new demands. - Supervisory approach and challenges: - Solvency II’s principles-based governance, risk management, and investment rules allow considerable use of own assumptions by insurers, increasing supervisory judgment demands. - Some aspects of BaFin’s approach remain relatively compliance-based; scope exists to shift focus to qualitative requirements and peer group review. - Retraining of supervisors and rethinking supervisory processes are under way and need to continue. ### Supervision of Groups and G-SII Framework - BaFin is implementing IAIS framework for G-SIIs where it has responsibilities. - Further development needed to implement IAIS proposals on additional loss-absorbing capacity; no single EU framework exists for this presently. - Scope exists to apply BaFin’s requirements on the one German domestic G-SII to other large groups that include reinsurance with global reach. - BaFin could consider applying macroprudential tools used for primary insurers (regular stress tests, recovery and resolution planning) to reinsurers, despite differing supervisory objectives and ongoing IAIS work on reinsurance systemic significance. ### Main Recommendations (high-level) - Continue monitoring companies likely to face strain and maintain a watchlist; require and enforce appropriate action plans where necessary. Priority: High. - Ensure companies using transitional measures have robust and credible plans to meet SCR requirements by the end of the 16 years period and, where possible, earlier; include stress testing to ensure SCR resilience after plausible shocks. Priority: High. - Keep the calibration of the ZZR requirement under review within a framework of close attention to national GAAP given its continuing importance to regulatory objectives and fair treatment of policyholders. Priority: Medium. - Shift supervisory priorities after full Solvency II implementation from internal models to assumptions used by insurers on the standardized approach and on investments. Priority: Medium. - Maintain supervisory and specialist resources at their current high level to manage ongoing Solvency II implementation challenges. Priority: Medium. - Plan proactively to ensure a high degree of public understanding of the different Solvency II measures and the multiplicity and transparency of solvency numbers (noting public disclosure requirements from 2017). Priority: High. - Improve communication to insurers, particularly larger companies, on BaFin’s key concerns and supervisory priorities (for example by disclosing more findings from the risk classification system). Priority: Medium. - Consider a more formal intervention approach in case of deterioration under national GAAP measures. Priority: High. - Consider a more systematic approach to communicate supervisory expectations based on ORSA review; make full use of supervisory legislation to require capital add-ons where envisaged in Solvency II. Priority: Medium. - Consider applying macroprudential tools used for the German G-SII to all larger groups (regular stress tests; recovery and resolution planning). Priority: Medium. - Empower BaFin to place additional regulatory requirements on G-SIIs, including requirements for additional loss-absorbing capacity being developed by the IAIS. Priority: Medium. *Source: IMF technical note — EXECUTIVE SUMMARY (German insurance sector), drawn on FSAP discussions in Germany, November 3–18, 2015.* ### 9. The 2011 FSAP highlighted a high degree of compliance with (the previous version of) ### _cr16192 - 9. The 2011 FSAP highlighted a high degree of compliance with (the previous version of) ### FSAP 2011 recommendations and follow-up - The 2011 FSAP identified areas for improvement relevant to this Technical Note: - Further development of a risk-based supervisory approach, including the expansion of group-wide supervision and supervision of insurers’ investments; progress addressed in the analysis of ICPs 9 and 15. - Development of stress-testing capacity and analysis of longer-term effects: ICPs 9 and 24. - Increase in the frequency and number of on-site inspections: ICP 9. - Increase in the number of staff with actuarial expertise and related quantitative skills: ICPs 2 and 9. - Enhancement of reporting requirements for insurers as well as shortening the time lags in the publication of aggregate insurance data: ICP 9. - Most of these recommendations have been addressed since 2011. Solvency II implementation has required BaFin to address these issues and many FSAP recommendations are reflected in the new supervisory approach. ### Insurance guarantee schemes - Statutory guarantee schemes have existed since the end of 2004 for: - Life insurance (scheme with ex ante financing arrangements). - Substitutive health insurance (scheme funded on an ex-post basis). - Key features and limits: - Schemes are supervised by BaFin. - Schemes have not been called upon to support a failing insurer to date; the life insurance scheme originated from a private mechanism used in 2003 for Mannheimer Life. - Role: provide continuity of insurance policies by transferring the portfolio of a troubled insurer to the scheme; BaFin can order such transfer without consent from the insurer, the guarantee scheme or policyholders. - Schemes do not compensate any loss caused by an insurance company’s failure; in principle claims are secured, but BaFin must reduce contractual benefits by up to five percent if the scheme’s resources are insufficient. - The scheme may amend insurance terms and tariffs of the transferred portfolio if reasonable; BaFin can take measures to prevent a large number of contract cancellations. - Funding specifics: - All life and private health insurers must be members of the guarantee schemes. - Life insurance scheme funding: up to 1 per mill of the net technical provisions of all members; currently the fund for life insurance has around EUR 900 million in assets. - If inadequate, special contributions of another 1 per mill of the net technical provisions can be levied from members. - In addition, life insurers have committed under private arrangements to raising a total of 1 percent of net technical provisions (around EUR 9.0 billion). - Health insurance scheme: funded on an ex-post basis; no contribution until a call is made. - No general guarantee fund for P&C insurers other than for motor vehicle third party liability insurance. ### Market structure, products and industry performance - Market breadth and assets: - There are 413 insurance companies supervised by BaFin; many are small mutual companies (139 in total). - Total investments of insurers in 2014: EUR 1,569 billion, composed of: - life insurers: EUR 911 billion, - health: EUR 232 billion, - P&C: EUR 154 billion, - reinsurers: EUR 272 billion. - Total assets of the banks are EUR 8,315 billion. - Number of insurers declined from 460 (2008) to 413. - Profitability and solvency: - Average ROEs in the last three years: - life: 6.6 percent, - P&C: 4.0 percent, - reinsurers: 8.3 percent. - Average solvency ratios at end-2014: - life insurers: 163 percent, - P&C: 312 percent, - reinsurers: 885 percent. - Note: many life insurers generated reported profits by recognizing unrealized gains on fixed income securities; underlying performance could be much lower than published figures. - P&C insurers face profitability pressures from competition and a pronounced underwriting cycle in motor insurance. - Investment profile: - Life insurers’ largest shares of investments (ratios against total assets unless mentioned): - government securities: 25 percent, - mortgage bonds: 21 percent, - bonds of financial institutions: 11 percent, - equity: 6 percent, - alternative investments: 1 percent, - mortgage loans: 6 percent, - other loans: 6 percent, - real estate: 4 percent. - Life and non-life insurers’ mortgage bonds accounted for 18 percent of total assets of life and non-life insurers at end-2014. - Product composition and distribution: - Products with minimum guarantees (including participating policies) dominate the German life market; unit-linked and related products account for less than 10 percent of total liabilities of life insurers. - Unit-linked products account for about 15 percent of total premium income in the last five years. - Non-life insurance dominated by traditional lines (motor, property, liability); credit and surety insurance less than 1 percent of total premium income. - Distribution channels: - single-tied agents: more than 40 percent in life and P&C, 50 percent in health insurance, - bancassurance: less than 20 percent of the market even in life sales. - Tied agents supported by relatively high levels of commission; expected to fall due to the Life Insurance Reform Act. ### Interconnectedness with banking sector - Bank—insurance linkages are limited and mostly domestic: - Bank liabilities financed by insurers fell from over 6.5 percent at end-2008 to around 4.5 percent in mid-2015. - Claims of banks on insurers fell from around 0.1 percent to 0.04 percent over the same period. - Almost all claims and liabilities of German banks towards the insurance sector in the EU result from linkages with German insurers. - Claims on banks: - Primary insurers’ claims on banks constitute a significant share of assets but are mostly internationally diversified, secured claims (e.g., Pfandbriefe/covered bonds). - Life insurers account for 67 percent of the total of primary insurance companies’ claims on banks. - About 25 percent of total investments are in German banks; these investments constitute about 5 percent of total liabilities of German banks (excluding derivatives). - About 50 percent of investments from insurers into banks are claims on the major German banking groups with an international focus; a significant share of total claims is through Pfandbriefbanken. - Conclusion: contagion risk from banks to insurers is limited unless collateral values deteriorate significantly; shocks in the banking sector would have a bigger impact on the insurance sector than vice versa. ### Main findings — Key risks and vulnerabilities - Search for yield and asset risks: - Share of corporate bonds in life insurers’ total investments increased from 4.3 percent in 2011 to 6.9 percent in 2014. - Average ratings in fixed income portfolios have reduced; AAA-rated securities portion fell from 44.8 percent to 35.6 percent between 2011 and 2013. - BBB-rated securities share rose from 7.1 percent to 12.8 percent between 2011 and 2013, reflecting rating migrations. - Increased investment in non-German sovereign bonds: Italian government bonds increased by 5 percent and Spanish government bonds by 25 percent from 2013 to 2014. - Investment in funds: - As of end-2013, life, health and P&C insurers allocated 23 percent of their assets to bond funds and 3 percent to equity funds. - Total investment in funds now exceeds over 30 percent of their assets. - Funds which cannot be looked through account for less than 2 percent of total assets. - BaFin insurance supervisors do not have access to data on derivatives used by funds and cannot require additional reporting beyond Solvency II templates (stipulated by EIOPA); derivatives are covered by EMIR reporting and BaFin is cooperating on an EMIR reporting system to enable insurance supervisors access to derivatives information. - Guarantee exposures and liability duration: - Guarantees on long-term life policies are significant; average guarantee rate has gradually reduced to 3 percent, while the maximum valuation interest rate for new contracts was reduced to 1.25 percent (see legislative changes). - Effective investment spread (internal measures from 2014 EIOPA stress test) had already turned negative (-0.4 percent). - Duration of liabilities of German life insurers could be estimated as approximately 11 years. - Impact of prolonged low interest rates and valuation/reserving challenges: - Maximum valuation interest rate for new contracts reduced to 1.25 percent as of January 1, 2015 (set by the Ministry of Finance); maximum rate applies only to new policies; guarantees for existing policies remain as when sold and cannot in practice be reduced. - National GAAP-based Additional Interest Provision (Zinszusatzreserve or ZZR) requires reserves for each policy guaranteeing a return above the reference rate for expected asset returns; required reserve equals the interest rate shortfall expected over the next 15 years; reference rate is the 10-year average of the zero-coupon euro swap rates with a duration of 10 years. - In 2014, EUR 8.4 billion was added to ZZR, resulting in over EUR 20 billion cumulative at year-end 2014. - If the reference rate keeps falling, additional ZZR will be needed; insurers expected to be required to continue to add to the reserve by more than EUR 10 billion annually from 2016, with cumulative reserves reaching over EUR 70 billion in 2018. - Majority of allocations to ZZR appear financed by realizing previously unrecognized gains; some insurers conducting costly transactions (e.g., sale and lease back of real estate) to generate gains to meet ZZR requirements. - Cyber risk awareness: - BaFin and the insurance industry are aware of cyber risks; global cyber risk market may now be worth some US$ 2 billion in annual premiums and German reinsurers are active in the market. - Cyber exposures can appear in general liability and household insurance (e.g., power outages due to cyberattack); insurers are redesigning policy terms, improving IT resilience, and BaFin is monitoring progress, including via the internal model approval process of Solvency II. ### Legislative and regulatory measures (Life Insurance Reform Act and Solvency-related) - Life Insurance Reform Act (2014) key measures: - Reduction of the maximum valuation interest rate for new insurance contracts from 1.75 percent to 1.25 percent as of January 1, 2015. - Limitation of policyholders’ dividends from unrealized gains from fixed income instruments: policyholders may now participate in valuation reserves of fixed-income securities only if valuation reserves are greater than the amount needed to safeguard the interests of continuing policyholders. - Flexibility for insurers to offset loss from investments with gain from insurance risk assumptions (such as mortality) when determining amounts to be allocated to policyholder dividends. - Increase in minimum allocation of policyholders’ dividends from insurance risk assumptions from 75 percent to 90 percent. - Net effect and market reaction: - The reduction in planned participation of policy-holders when policies mature is significant. - Market participants view the reform measures as mixed but overall net beneficial for long term financial soundness of life insurers. - Solvency I GAAP and transition considerations: - National GAAP-based valuation requirements including ZZR continue to apply after January 1, 2016 for accounting purposes. - Near-term risk: some life insurers’ financial situation under national GAAP may worsen and diverge from Solvency II-based measurement if low interest rates persist. *Source: IMF staff report content provided in the supplied PDF extract.* ### 32. The authorities have been in the process of implementing Solvency II for a number of ### _cr16192 - 32. The authorities have been in the process of implementing Solvency II for a number of ### Implementation process and preparatory work - BaFin worked within the 2014 guidelines of the EIOPA, in particular its two-year preparation phase, which established four key areas of work: - Requirements for business organization and risk management; - Forward-looking assessment of own risks; - Pre-application for internal models; and - Reporting. - The approach applies to all insurers, reinsurers and groups to which Solvency II applies (around 90 percent of all insurers with a much larger aggregate share of the total market). - BaFin took account of likely Solvency II demands in supervisory discussions prior to 2014, for example on establishing required control functions. ### Legislation and regulatory framework - The Act to Modernise Financial Supervision of Insurance Undertakings, enacted in April 2015, sets out: - new valuation requirements; - own funds rules; - provisions on the calculation of the Solvency Capital Requirement (SCR); - governance requirements for insurers; - a new framework for supervision of insurance groups; - adjustments available to insurers offering long-term guarantees; and - Solvency II’s transitional arrangements, aimed at cushioning the impact of the new requirements in the 16 years out to 2032. ### Reporting, disclosure, and supervisory tracking - BaFin required insurers to use standardized status reports to track implementation progress, dividing preparatory work into 15 thematic blocks to focus supervisory and on-site work. - Emphasis placed on reporting and disclosure requirements: - Challenges for insurers in ensuring accuracy and completeness of reporting at group and company level; - Challenges for BaFin in building the required database, analysis and supervisory capacity for use from January 2016. - During 2015 BaFin required insurers—on a voluntary basis—to submit: - annual narrative and quantitative reporting; - third quarter quantitative reporting. - Most German insurers submitted QRTs (Quantitative Reporting Template) using XBRL and submitted narrative reporting (Regular Supervisory Report (RSR)) corresponding to a subset of envisaged future reporting. ### Internal models and quantitative capability - Preparatory work for internal models has been a major focus: - BaFin established a separate central unit on quantitative issues (now 18 staff, up from 13 in 2010). - Since 2009 BaFin worked on pre-application of six groups planning to apply for internal models, reviewing key model features, model governance, and the “use test”. - Adequacy of documentation and model validation were key focuses, involving extensive on-site work. - For international groups, internal model work carried out jointly with other supervisors via core teams; BaFin participated in EIOPA’s Solvency II internal models committee (no role in individual approvals). - Internal model approval decisions were being made in late 2015 under collective decision-taking arrangements; BaFin leads decisions where it is group supervisor and has access/decision role where it is host supervisor. ### Options requiring BaFin approval and supervisory stance - Other options requiring BaFin approval include: - Models may be used on a full or partial basis; - Provision for undertaking-specific parameters in the SCR standard formula; - Use of transitional measures for calculation of technical provisions; - Use of the volatility adjustment for deriving the risk-free rate curve; and - Allowance of ancillary own fund items. - BaFin advised that applications for internal model approval should be from companies with the most advanced risk management frameworks. - Relatively few insurers applied for internal model approval compared with some other EU countries; more applied for volatility adjustment and transitional measures. - BaFin discussed with life insurers potential application of these approaches to reduce likelihood of not meeting SCR; BaFin approval remains required. ### Guidance, market-specific issues, and surveys - BaFin identified market-specific issues requiring guidance, notably on adjusting own funds components (surplus fund and future discretionary benefits) to avoid double-counting of loss absorption capacity stemming from potential reduction of potential dividends to policyholders—reflecting German arrangements for surplus allocation between policyholders and shareholders on traditional life policies. - Surveys and stress assessments: - A survey based on balance sheets at December 31, 2013, with projected numbers as of January 1, 2016, conducted in 2014; insurers provided updated numbers mid-2015 based on end-December 2014 positions in response to further falls in interest rates. - Results used to identify insurers with less strong solvency positions (below or near SCR), prompting discussions on potential transitional measures. - Life insurers targeted due to pressures in low interest rate environment; all life insurers subject to Solvency II had to submit reports. - Survey findings: - Initial survey: only a few insurers with a collective market share of less than 1 percent were unable to show they could meet new requirements despite applying transitional measures. Without transitional measures, about 25 percent of insurers, with a collective market share of about 10 percent, would not meet the SCR as of December 31, 2013. - Second survey (end-2014 positions): number unable to show they could meet SCR had not increased, but almost half of all insurers were dependent on use of transitional measures to meet their SCR and would have had a collective shortfall of some EUR 12 billion in own funds (which compares with some EUR 60 billion in total life sector own funds). ### Long-term guarantee measures and transitional arrangements (Box 1 summary) - EIOPA Long-Term Guarantee Impact Assessment (early 2013) found that under Solvency II with no long-term guarantee measures, more than half of participating life insurers across the EU would have been undercapitalized; adjustments were developed to reduce these cases. - Measures include: - Matching adjustment (permanent): applied to yield curves for valuation of predictable liabilities cash-flow matched using fixed income assets; requires supervisory approval and conditions (portfolio matching, separate management, limited policyholder options, restricted redemption). - Volatility adjustment (permanent): aims to avoid pro-cyclical investment behavior when bond prices deteriorate due to low liquidity or exceptional spread widening; stabilizes capital resources and will be set by EIOPA. - 16 years transitional arrangement: allows insurers, on BaFin’s approval, to use discount rates applying in December 2015 for valuation of contracts concluded before start of January 2016, with linear phasing out to zero by end-2032 (example: benefit reduced by half by 2024). - BaFin introduced an additional measure to limit the transitional benefit so Solvency II requirements (with this arrangement) are more conservative than insolvency measured by national GAAP. - Insurers using matching adjustment, volatility adjustment and transitional arrangements must disclose Solvency II figures with and without these measures. - German life insurers most likely to use the volatility adjustment; matching adjustment conditions likely hard for them to meet. - Some large insurers already announced they can meet Solvency II without transitional arrangements. - Transparency of measures implies supervisory attention to interpretation by policyholders and market participants. ### Sector-specific findings - Health insurers: - Surveyed by Association of Private Health Insurers in 2014 and 2015 on a basis similar to BaFin’s life insurer survey. - Almost all participated and all were able to meet new requirements despite low interest rates; private health insurers can adjust premium rates to compensate for low interest rates. - P&C insurers and reinsurers: - Not subject to BaFin surveys of the same type as life insurers; BaFin viewed impact as more limited. - Supervisors held management discussions for major companies; many large/listed companies disclosed expected impacts. - Majority participated in voluntary quarterly and annual reporting; some included in EIOPA group level stress test 2014. - QRT reporting on end-2014 financial positions covered about 90 percent of all insurers. ### Assessment, supervisory implications, and recommendations - Implementation management: - Solvency II implementation process considered rigorously managed; regulatory work largely complete as at end-2015 though some detailed measures outstanding. - BaFin deployed expert resources for internal models, requiring unprecedented international cooperation and internal preparations including training. - Industry feedback highlighted thoroughness and rigorous follow-up; international coordination important though not always achieving agreement among supervisors. - BaFin’s insurance and pension fund supervision directorate staff increased by 35 percent since 2010; specialist models unit grew. - Remaining uncertainties and supervisory posture: - Uncertainty about likely impact on insurance sector remains because BaFin collected voluntary test reporting only and market conditions continue to evolve. - BaFin maintains a watchlist of companies that may not meet Solvency II SCR and is in ongoing discussions with such insurers. - Intensive supervisory approach required during initial live reporting and future market volatility given sensitivity of Solvency II balance sheets and SCR to market price changes. - Policy recommendations and supervisory actions advocated: - BaFin should continue to plan management of the transitional period, assuming many companies will be affected. - Insurers using transitional measures must submit an annual report to BaFin describing measures to increase capital or reduce risk profile to meet SCR without transitional measures. - A structured process and regular BaFin reporting on progress (modelled on 2014 and 2015 survey publications) will help ensure confidence in integrity of the transition. - Supervisory oversight required to ensure complexity of Solvency II calculations does not lead to under-valuation or misreporting, even for insurers using standardized approaches. - Continued attention to national GAAP standards for insurers (including ZZR) is important given national GAAP’s role in policyholder bonus allocations, inputs into Solvency II calculations, and insolvency measurement. - The calibration of the ZZR should be kept under review in light of prevailing interest rates. ### Structural and accounting challenges - Market-consistent valuation under Solvency II vs national GAAP: - Solvency II’s market-consistent valuation is a major change for German life insurance; German GAAP historically used historic cost principles with liabilities valued at valuation rate at contract sale and assets at lower of cost and market—insensitive to market changes. - Market-consistent approach in a continuing low interest rate environment would require many life companies to raise significant new capital, even where risks may not materialize for years and where insurers remain solvent under national GAAP. - This dynamic is likely to accelerate business model changes that would eventually be required under historic cost accounting. - Complexity in Germany: - Implementation in Germany is more complex than in other EU countries due to insurance product features and continuing importance of national GAAP. - Policyholder bonuses remain determined on national GAAP, requiring life insurers to project future national GAAP valuations to estimate discretionary bonuses and other inputs (deferred tax assets/liabilities) into Solvency II calculations. - National GAAP significantly affects Solvency II figures though Solvency II applies only to regulatory solvency calculation. - Even insurers using standardized approaches need complex models for solvency computations. *Source: _cr16192 - 32.* ### 53. Even though the impact of Solvency II market consistent valuation is subject to ### _cr16192 - 53. Even though the impact of Solvency II market consistent valuation is subject to ### Impact on business models and product offerings - Expected business model changes are occurring despite dampening and transitional measures under Solvency II. - Predominance of traditional products in German life insurance reflects policyholder preference for guarantees and past/present tax advantages (endowment policies until the late 1990s; present tax advantages for annuities). - Riester policies sold as a substitute for social insurance are required by law to have guarantees. - An increasing number of insurers have announced a withdrawal from traditional policies, reflecting a combination of the low rates environment and Solvency II. ### Impact on financial position and product mix - Changes in the product mix will have a slow effect on insurers’ financial positions due to: - Many new products still offering guarantees (shorter periods or limited to value of premiums paid). - Increasing sales of hybrid policies (unit-linked with a guaranteed element); sales of pure unit-linked policies remain limited. - The scale of past business and inability to change guarantee provisions of past policies. - Constraints on disposing of old business in the current market environment, despite legal provisions for portfolio transfers subject to BaFin approval. - Limited merger activity involving life companies to date, though this may increase. - BaFin is well-equipped to assess and approve portfolio transfers and other changes. ### Investment policies and risk appetite - Solvency II implementation has influenced investment policies; evidence of search for yield by life insurers in the low interest rate environment. - Insurers noted that expectations of new, more risk-sensitive capital requirements are deterring them from taking on more risk in investment portfolios. ### BaFin transition, supervisory capacity, and approach - BaFin plans continued staff training and broader change management to complete internal transition to Solvency II. - Observations by the FSAP mission: - High degree of awareness of key features of the new regime. - Transition started early and is a continuing process; most supervisors experienced in evaluating governance, risk management requirements, and impact on solvency measurement. - Supervisors need to maintain understanding of national GAAP for inputs into distribution of surplus, solvency calculations, portfolio transfers, and triggering insolvency. - Supervisors of groups approved to use internal models must incorporate understanding of key properties of such models into supervision. - BaFin plans to maintain specialist resources with a program of continuing model reviews. - Delivering effective supervision in a more principles and risk-based framework is challenging: - Some Solvency II aspects (governance, risk management, new investment rules) are more principles-based, leaving scope for insurers to use own assumptions. - More judgment will be demanded of supervisors; limited reliance on mainly quantitative analysis or compliance-based supervision. - More limited scope to gather evidence of specific non-compliance before intervening, if intervention is to be effective. ### Opportunities to deepen supervisory reform and communication - FSAP mission noted scope for further change: reduce time spent on routine or reactive processes and internal reporting on financial returns, subject to consistency needs. - Developing risk classification system is a valuable tool for prioritizing supervisory work and communications with insurer senior management. - Need to ensure senior management of insurers are fully apprised of BaFin’s supervisory view and expected actions; risk classification output should support this communication. - External communications on Solvency II impact must be carefully managed: - Much external communication has focused on insurers and market participants and on implementation progress. - Future disclosures will be governed in part by EIOPA’s technical standard on scope and granularity of public supervisory information. - Guidance for policyholders, agents and others should be prioritized given challenges interpreting insurance disclosures in Germany because of national GAAP and widespread use of transitional measures. ### The relationship between Solvency II and national GAAP (Box 2) - Solvency II introduces a more market consistent approach to valuation, but in Germany only for solvency (supervisory) purposes. - Prior to Solvency II, German insurers used national accounting standards for both financial reporting and supervisory purposes; national GAAP requires a broadly lower-of-cost-and-market value approach. - Solvency II requires broadly market consistent valuation of assets (market value) and liabilities (best estimate of future cash flow plus explicit risk margin), but used in Germany only for solvency purposes. - National GAAP remains important as input into solvency calculation and wider purposes: - National GAAP remains the basis for insurers to calculate dividends for shareholders. - National GAAP is used in calculation of bonuses for policyholders under contractual provisions of life insurance policies (majority outstanding) which give policyholders profit participation rights. - Insurers must include future discretionary bonuses payable to policyholders in cash flow calculation for valuation and can deduct from capital requirements an amount for loss absorption capacity based on the future discretionary bonus reflected in technical provisions (see Annex, ICP 17). - National GAAP is also the basis for calculation of “guarantee assets” held as a source of policyholder protection in case of insolvency (see Annex, ICP 12). - Relationship between national GAAP and Solvency II figures: - Under the current low interest rate environment, Solvency II produces a generally more conservative result than national GAAP (a less strong financial position). - Adjustments to national GAAP (such as Additional Premium Reserve requirements or ZZR) and to Solvency II figures (including the 16- year transitional arrangement and volatility adjustments) mean figures based on national GAAP will be the binding constraint on many insurers in the short to medium term. - In a normal market environment for interest rates, the relationship will be influenced by Solvency II critical assumptions (including the Ultimate Forward Rate and basis for extrapolation of longer term rates) which are not as conservative as valuation requirements under national GAAP. - Consequences and recommendations from Box 2: - German implementation of Solvency II is relatively complex and communicating industry financial position and basis for policyholder bonuses will be challenging. - Explanation of financial soundness cannot be made without also explaining interaction of the two valuation regimes. - Establishing fairness in allocation of surplus to policyholders may be harder due to insurers’ high degree of discretion in policyholder bonus payments; Solvency II figures assume bonuses will be significantly reduced under certain stress scenarios. - Advantages exist in aligning national GAAP with Solvency II valuation in the medium to long term; current dual approach is complex, risks misunderstanding, and may delay decision-making in stress. - Consideration should be given, in the medium to long term, to aligning valuation standards used for financial reporting and related purposes (including determination of policyholder bonuses) with those used for solvency requirements as far as possible, building on steps already taken with the ZZR. ### Supervision of groups: structure, coverage, and practices - Solvency II has driven development of a more risk-based approach, allowing increased resources to focus on large insurance groups. - BaFin’s group supervision differentiates between three overlapping sets of groups: - The 14 insurance groups regarded as significant. BaFin applies its risk-based supervision framework on a group basis, including a risk classification system that classifies companies and groups by impact (Very High, High, Medium and Low) as well as quality. - The 17 insurance groups with subsidiaries incorporated outside Germany. BaFin leads colleges of supervisors for these groups where required under EU legislation and German supervisory law; it also participates as host supervisor in colleges for a further 14 groups based outside Germany. Key college processes include group risk assessment, crisis preparedness, and Solvency II internal models approval. BaFin involves non-EEA supervisors in some cases, subject to assurances on confidentiality. - The one G-SII for which BaFin is the group supervisor. BaFin has established both a college of supervisors and a Crisis Management Group (CMG) in accordance with the Financial Stability Board’s framework for Global Systemically Important Financial Institutions. BaFin also participates as host supervisor for one other G-SII and one former G-SII (G-SII arrangements continued to apply as at late 2015). College work has focused on internal models approvals and on recovery and resolution planning through the CMG. - Insurance-dominated financial conglomerates: - Six financial conglomerates of which BaFin is the coordinating supervisor, four of which are insurance dominated. - Two financial conglomerates with large insurers in Germany where other EU supervisors are coordinating supervisors; BaFin invites the non-insurance supervisors to the colleges it leads for the four insurance-dominated conglomerates. - Reorganization of supervisory resources: - Since July 2014, one team now supervises all or most elements of each group. - The three largest groups (Allianz, Munich Re and HDI/Talanx) are supervised by a single unit each. - The three largest groups and the German operations of the foreign G-SII (and former G-SII) are supervised in a single department to enable exchange of supervisory views. - Supervision units comprise between 9 and 14 staff supported by specialist functions, including the internal models unit. The core supervisory team consists of at least one legal expert, an economist and a mathematician or actuary. - Distinctive approach for largest groups emphasizes: - A supervisory plan drawing on risk classification, BaFin’s priorities, college agenda, and workstreams such as the ORSA review. - Particular focus on internal management information (e.g., internal group risk report received quarterly). - Regular contact with senior management, including heads of control functions and the responsible actuary. - Annual attendance at meetings of the group’s supervisory board and receipt of board papers and minutes. - Working through the college of supervisors. - Regulatory framework and powers: - Until January 1 2016, approach based on the European supplementary supervision framework; BaFin has applied governance and risk management requirements to group level as well as intra-group transactions and risk concentrations. - Solvency II deepened the regulatory approach with extended reporting for insurance groups and recognition of internal models at group level. - BaFin has direct powers over insurance holding companies and mixed financial holding companies, enabling comprehensive groupwide supervision. - There is extensive internal guidance and specialist expertise on group supervision issues. - G-SII-specific issues: - No provisions in law explicitly recognizing separate status of G-SII. BaFin’s work on G-SIIs has been undertaken without using specific powers, relying on authority over regulated entities. BaFin has no power to impose additional capital requirements on a G-SII (as planned under the developing IAIS HLA framework). - BaFin has implemented elements of IAIS G-SII supervision agreed to date, including initial assessment methodology, requiring a Systemic Risk Management Plan, Liquidity Risk Management Plan and establishment of a CMG. - Scope to further align BaFin’s approach to the one German G-SII with other larger groups, including potential application to reinsurance-led groups of macroprudential tools used in primary insurance (regular stress tests, recovery and resolution planning), pending outcome of IAIS review of G-SII assessment methodology. ### Key recommendations (A. Key Recommendations) - BaFin should continue to maintain a watchlist and continue to require action plans where companies face difficulties in meeting the new solvency requirements or maintaining a surplus under the national GAAP. - BaFin should ensure that companies using the transitional measures under Solvency II have a robust and credible plan for meeting their SCR requirements by the end of the 16 year-period and, where possible, earlier. This process should include stress testing to ensure that such insurers would meet the SCR even after a plausible shock. - The calibration of ZZR requirement should be kept under review within a framework of close attention by the authorities to the national GAAP framework as it applies to insurers given its continuing importance in relation to insurance regulatory objectives, including fair treatment of policyholders. - Supervisory priorities following full implementation of Solvency II should shift to the assumptions used by insurers using the standardized approach and on investments. - Supervisory and specialist resources should be maintained at their current high level to manage the continuing challenge of implementation and risks that will arise during the early period after the new requirements come fully into effect. - Given the multiplicity and high transparency of Solvency II numbers that will be available (particularly from 2017 when public disclosure requirements take effect), planning should be undertaken to ensure a high degree of public understanding of the different measures. - BaFin should consider a more formal approach to intervention in case of a deterioration in the financial position of an insurer as measured under the national accounting framework. - BaFin should also consider a more systematic approach to communicate requirements based on the ORSA review; and a policy framework for the imposition (and removal) of formal capital add-ons, making use of its powers in the insurance supervisory legislation. - BaFin could consider the application to all the larger groups of macroprudential tools used in the case of the one German G-SII, including regular stress tests and recovery and resolution planning. - BaFin should be empowered to place additional regulatory requirements on G-SIIs, including the requirements for higher loss-absorbency capacity being developed by the IAIS. ### Other recommendations (B. Other Recommendations) - The federal government should review BaFin’s extensive reporting requirements to the BMF and provisions for dismissal of BaFin Executive Board members to ensure they continue to support robust operational independence in the future. - BaFin should further develop its supervisory approach to place increased emphasis on peer group analysis and peer review, especially on larger institutions; and to take a more risk-based approach to the allocation of supervisory resources to conduct of business work, for example by including more explicit conduct-related issues in its risk classification system. - The authorities should review whether the procedures to effect transfers of insurance portfolios to guarantee schemes allow for more complex portfolios readily to be transferred; and whether it would strengthen BaFin’s ability to address weak insurers if it were to have a power to require a portfolio transfer to another (willing) insurer as well as to an insurance guarantee scheme. - In the long term, there would be advantages, from the perspective of insurance supervision, in aligning national GAAP with Solvency II valuation as much as possible to help the authorities and insurers communicate the industry’s performance more clearly and to avoid unnecessary uncertainty in the market over valuation and solvency. - Insurance supervisors should continue to coordinate with securities supervisors to monitor derivatives activities used by investment funds in which insurers are investing, given the significant share of investment allocation by insurers. - BaFin should use the analysis developed in internal model validations to assess the SCR under the standardized approach, for example whether the assumptions on policyholder dividend reduction under certain scenarios or of taxable income for deferred tax are realistic. - If the volatility adjustment is to be widely used by insurers, BaFin should encourage them to build up capital resources during periods of low volatility so that the volatility adjustment is used solely for countercyclical purposes. - The FSC and German government should consider the scope for giving the FSC wider scope to take macroprudential action without the need for legislative change—to address the risk that necessary measures are delayed or not implemented owing to the political cycle. - BaFin should make use of its powers to require significant insurers to develop recovery plans, starting with higher risk insurers under the risk classification system; and address gaps in the regulatory framework in relation to requiring companies to be ready to report necessary information in case of a crisis and to maintain contingency plans. *IMF Staff Country Report content as provided in the supplied PDF excerpt.* ### Annex I. Detailed Analysis of Selected ICPs ### Annex I. Detailed Analysis of Selected ICPs ### ICP 2 — Supervisor: governance, independence, confidentiality, resources, professional standards - Governance and organizational framework - BaFin is the federal authority for financial supervision; state (Land) authorities supervise publicly-owned insurers limited to the relevant state and private insurers of lesser economic significance, representing in total 0.1 percent of the total premium income of the market. - Insurance intermediaries are subject to licensing and supervision by the Chambers of Industry and Commerce (IHK). - Governing instruments: FinDAG, rules of internal procedure, organizational statute (OSBaFin), and Articles of Association. - Administrative Council: 20-member body comprising members from federal ministries, members of the Federal Parliament and representatives from financial services; monitors management, supports BaFin in execution of duties, adopts the budget and approves annual accounts; the Bundesbank may be represented but has no voting right; the Council does not consider individual supervisory cases. - Executive Board: governs day-to-day; comprises the President (responsible for strategic direction) and four Chief Executive Directors, one responsible for insurance and pension fund supervision; President reports regularly to Administrative Council. - Advisory Board: 24-member, provides advice and recommendations on supervisory practice; there is also an Insurance Advisory Council composed of insurance experts. - Internal Audit Office reports directly to the President. - Appointment and dismissal: President and Executive Board appointed by the Federal President on the proposal of the government for eight year terms of office; members of the Administrative Council appointed by the Federal Ministries; the Federal President may dismiss an Executive Board member on demand or on the basis of a decision of the German government for cause; there is no provision for publication of the reasons for a dismissal. (FinDAG s7-9) - Executive Board is responsible for all decisions on regulatory and supervisory matters; no provision for escalation to Administrative Council or Ministry of Finance; operational decisions are delegated with escalation of major decisions to the Executive Board. - Responsibility to the Federal Government - BaFin is part of the executive branch and is responsible to the Federal Parliament via the BMF; status as a federal institution with legal personality governed by public law and part of the BMF portfolio. (FinDAG s1) - Relationship with BMF governed by FinDAG and by the Principles governing the exercise of legal and technical supervision of BaFin by the Federal Ministry of Finance, May 2013. - BMF’s role includes chairing the Administrative Council, budgetary approval powers, and oversight of legality and fitness for purpose of BaFin’s administrative actions; BaFin must make extensive reports to the BMF on organizational and supervisory issues, including supervisory measures of material importance and noteworthy events at systemically important and smaller institutions. (Principles, section III) - BaFin’s Articles of Association recognize the right of the BMF to issue instructions to BaFin’s Executive Board. - Transparency and rights of appeal - BaFin required to publish legal and administrative measures in its monthly Official Bulletin and annual report (published on the website). - Supervisory processes set out in circulars, guidelines, proclamations and announcements; no requirement for regular review but requirements are reviewed and reissued as necessary (major revisions for Solvency II implementation). - BaFin publishes annual information on the insurance sector, financial situation and significant market trends. - Decisions subject to appeal under the Code of Administrative Court Procedures; supervisory legislation explicitly provides that objections against most intervention measures do not have suspensive effect (including decisions to appoint an auditor, impose capital add-ons, require solvency or finance plans, restrict payments or reduce liabilities, initiate insolvency proceedings and take any action to address irregularities). (see ICP10) - Confidentiality and information sharing - BaFin staff, engaged experts and advisory body members must not pass on confidential information that could identify the individual insurer. (VAG2016 s309) - Confidential information includes business secrets of insurers and insured and any information provided on condition of confidentiality; breach penalized under the Criminal Code. - BaFin may pass on confidential information to authorities responsible for financial supervision and to central banks, including specific provision to share information with the ECB, the Eurosystem and other EU authorities. (VAG2016 s309 (5)) - Information may be shared with competent authorities of non-EEA countries only if protection is guaranteed by professional secrecy to the same extent as under the VAG. - Liability - BaFin’s liability is limited under law; it cannot be liable to third parties except in cases of an abuse of authority or negligence. (FinDAG, s4) - In case of breach of official obligations by a BaFin employee, liability rests with BaFin unless the official is guilty of willful intent or gross negligence, in which case BaFin has the right of recourse. - Resources and staffing - BaFin is financed from fees and charges imposed on supervised institutions and receives no funding from the federal budget; main funding sources are fees for specific measures and charges allocated to each sector on the basis of costs of supervision; BaFin’s budget is approved by its Administrative Council. - BaFin may recruit and deploy staff as required; employs both civil servants and public employees; may hire, contract or retain external specialists through contracts or outsourcing arrangements. - Staff training recently focused on Solvency II preparations; in 2014, professional development per employee averaged 4 days. - As at November 2015, BaFin employed 349 staff in its insurance and pension fund department compared with 266 in 2010. - Insurance supervision draws on cross-sector expertise on risk modelling (including 18 working on internal model validation of insurers, up from 13 in 2010), consumer protection and anti-money laundering. - Professional standards and conduct - Staff subject to standards applicable to their employment and supervisory work; general Code of Conduct on prevention of corruption; rules on acceptance of gifts in the BBG and TVöD; Code of Conduct governing share-dealing and investing in supervised companies; Codes apply to all staff members. - Comments and recommendations - Responsibilities for regulation and supervision are clearly divided between the federal government and BaFin; BaFin is subject to federal oversight and extensive reporting requirements to the BMF. - BaFin is operationally independent in practice and not subject to government instruction in supervisory decisions; funded directly from industry with flexibility in recruitment and remuneration, enabling recruitment and retention of specialist staff during Solvency II implementation. - Approach to resource allocation has become more risk-based, with greater focus on groups (and large groups in particular) and a balance between frontline supervisory and specialist resources. - Preparations for Solvency II include a change management program to support staff moving from rules/compliance-based to risk/principles-based supervision. - It is recommended that: - BaFin continue to keep under review the program of staff development in line with the demands of Solvency II supervision, including integrating the oversight of internal models, once approved, with other supervisory work; and - The federal government review BaFin’s reporting requirements to the BMF and provisions for dismissal of BaFin Executive Board members to ensure they continue to support robust operational independence in the future. ### ICP 6 — Changes in Control and Portfolio Transfers - Scope and notification requirements - Supervisory approval required for proposals to acquire significant ownership or an interest in an insurer that results in control, and for portfolio transfers or mergers. - Qualifying holdings defined as a 10 percent holding of nominal capital or voting rights or decisive influence on management. - An acquiring party must notify BaFin of a proposal to acquire a qualifying holding or to increase holdings above thresholds of 20 percent, 30 percent and 50 percent. (VAG2016 s16-22) - Reductions in shareholdings must be notified to BaFin by insurers and shareholders; insurers must notify BaFin annually of their stock of shareholders. (VAG2016, s47 (7)) - Legislation covers direct and indirect holdings and BaFin can require notification of ultimate beneficial owners; insurers must notify BaFin when aware of acquisition of a qualifying holding. (VAG2016, s47 (5)) - Decision timelines and assessment criteria - BaFin has 60 working days to make a decision on applications (starting from when the supporting documentation is complete), subject to extension if more information is requested, particularly where the acquirer is from outside the EEA or is not an EEA regulated entity. (VAG2016 s17 (4)) - BaFin must consult with the relevant authority. (VAG2016 s21) - Assessment criteria aligned to licensing conditions, including that complex ownership webs or lack of transparency should not hinder effective supervision and that a non-EEA foreign insurer seeking acquisition is subject to effective supervision. (VAG2016 s18) - BaFin maintains dedicated resources to process transactions. - Experience and practice - BaFin has processed a small number of changes in control in recent years, many reflecting internal reorganizations or mergers, averaging eight per year. - BaFin has not recently refused a change of control, although it did suspend voting rights of a significant shareholder in a small insurance company in one case (the company subsequently went into insolvency). - Portfolio transfers - Transfers of portfolios by primary insurers and reinsurers are subject to approval by the applicable supervisory authorities; in relevant cases only the home state supervisory authority must give approval. - Requirements for consultation between EEA authorities and specific assurances required where transfer is to a non-EEA insurer. (VAG2016 s13, s63, s73, s166, s200) - BaFin bases decisions on whether interests of insured parties are safeguarded and whether obligations under insurance contracts can be fulfilled at all times. - For participating policies, BaFin can approve a transfer only when satisfied that profit participation of policyholders (in both transferor and transferee) are no less than before the transfer, using a fair value approach to measurement of assets and liabilities. - BaFin acts in place of policyholders in relation to acceptance of a portfolio transfer; policyholders have rights after transfer to be informed and to terminate their policy (and only if a change in regulatory authority results from the transfer). (VAG2016 s13 (7)) - BaFin’s decision must be published; policyholders may apply to a Court for a judgment on whether rights have been infringed. - BaFin processes only a small number of portfolio transfers per year and has not in recent years refused any applications. - Separate requirements apply where portfolio transfer is of life or health insurance portfolios to an insurance guarantee scheme. (VAG2016 s222) - Comments - Legislation and BaFin’s powers ensure changes in control are notified and that BaFin can prevent changes that could place policyholders at risk. - BaFin is well-equipped to address increased merger activity and fully empowered to approve portfolio transfers with regard for policyholder interests. - BaFin may, where legislative conditions are met, require a portfolio transfer to an insurance guarantee scheme but cannot otherwise require a transfer. - The process creates some risk of uncertainty after a transfer if policyholders challenge BaFin’s decision before the Court; no such challenge has ever been made. ### ICP 9 — Supervisory Review and Reporting - Legal basis and powers to obtain information - Legal authority and duty to undertake supervision set out in the VAG with emphasis on financial supervision and safeguarding interests of the insured. (VAG2016 s294) - BaFin has powers to obtain information from: - Insurers, governing body members, employees and controllers (may include documentation given to policyholders, and outsourcing contracts); - Other companies in the group of which the insurer is a member to support group-wide supervision (where insurer has not provided the information); - Insurance agents and brokers, where required for assessment of an insurer; and - Outsourced service providers, auditors and trustees. - BaFin has powers of access to insurers and these other parties (except other group companies) and a right to attend and speak at supervisory board and general meetings of an insurer. (VAG2016 s305-6) - Supervisory framework and risk-based approach - BaFin has been developing a risk-based approach that allocates resources and supervisory priorities to individual insurers and 14 significant insurance groups according to scale and risk, measured as the quality of the insurer. - Core processes: off-site analysis based on extensive reporting and on-site supervisory work driven by a risk classification system assessing impact (size) and quality (quantitative indicators and supervisory assessment of governance and qualitative factors). - Conduct risks are captured through indicators related to management quality. - Each insurer is assigned an impact and a quality score; neither is communicated to the insurer, although aggregate results are published. - Impact classification recently extended with an impact category of Very High to identify a small number of the most significant companies for the German market; implications for supervisory approach to these companies are being developed. - On-site work prioritization and minimum frequencies - Main output of risk classification is prioritization of on-site work in the annual BaFin plan. - Minimum requirements on frequency of on-site work: medium impact insurers — eight to ten years; low impact insurers — ten to twelve years. - Organization and resourcing of supervision - Supervision undertaken by units of between 9 and 14 staff supported by specialist functions within the Insurance and Pension Fund Supervision Directorate and an internal models unit (to become part of the Directorate in 2016). - Core supervisory team consists of at least one legal expert, an economist and a mathematician or actuary. - Since July 2015, supervision organized on a group basis: one team now supervises all or most elements of each group to provide group focus; the three major groups are supervised by a single unit within one department, while other units supervise a varying number of companies depending on scale. - Supervisory practice, reporting and tools - All insurers subject to off-site supervisory review based on quarterly and annual reporting (including financial reporting received initially in draft soon after year-end); external auditor’s report; actuary’s report; and the risk report (a key internal document BaFin requires companies to share, to be superseded by ORSA reporting). - Supervisors submit written analysis on key reports within specified periods after receipt. - Stress testing undertaken annually in recent years with reporting integrated into supervisory process and macroprudential supervision (ICP24); current approach being replaced in 2016 with reviews of insurers’ ORSAs. - BaFin undertakes ad hoc surveys of all or relevant insurers (for example on response to adverse market developments). - Reporting to BaFin is being greatly enhanced under Solvency II requirements. *Source: IMF staff compilation from Annex I. Detailed Analysis of Selected ICPs (excerpt).* ### 2016. More detailed reports on the financial position and risks of insurers will be ### 2016. More detailed reports on the financial position and risks of insurers will be ### Reporting, On-site Work, and Preparations for Solvency II - From 2016 insurers will publicly disclose a Solvency and Financial Condition Report (SFCR) and submit a Regular Supervisory Report (RSR). - BaFin will receive detailed quantitative information both quarterly and annually. - Reporting of group information will be extended beyond the previous EU supplementary supervision framework and published information. - BaFin was adapting internal systems (including its database and analysis IT systems) and its risk classification approach at the time of the FSAP. - On-site work in recent years focused on preparations for Solvency II: - Extensive on-site evaluation of technical and broader aspects of internal models for groups applying for approval, in Germany and other countries. - Regular on-site inspections concentrated on Solvency II issues, including risk management requirements, adequacy of control functions, and impact on business models. - Other issues covered when rated significant risk or in response to a specific insurer event. - Routine on-site reports: - Typically one or two weeks in duration. - Carried out by BaFin supervisors and followed up promptly with reports to management. - BaFin almost always uses its own staff rather than contracting external experts. ### Group Supervision for the Largest Groups - Developing group supervision approach emphasizing: - A supervisory plan drawing on risk classification, BaFin priorities, college agenda, and workstreams such as the ORSA review. - Focus on internal management information (e.g., risk report received quarterly). - Regular contact with senior management, including heads of control functions and the responsible actuary. - Annual attendance at supervisory board meetings and receipt of papers and minutes. - Working through the college of supervisors (ICP25). - Supervisory responsibilities for insurer conduct of business fall to supervisory teams, supported by a specialist unit that leads cross-firm projects and issues related to indirect supervision of intermediaries (see ICP19). - Recent on-site examples: reviews of sales practices and claims handling. ### Comments and Recommendations on Supervisory Review - BaFin is rebalancing from routine and reactive work to more forward-looking, risk-based supervision covering core financial soundness, risk management, qualitative requirements, and conduct of business. - Recommendations: - Consider integrating qualitative and quantitative dimensions of the off-site review process; place more weight on qualitative elements in the risk classification framework and ORSA review; and impose capital add-ons for qualitative concerns. - Develop enhanced peer group analysis and peer review/challenge in agreeing risk assessments and supervisory planning, especially for larger institutions. - Consider disclosing risk classification findings to better communicate key concerns and supervisory priorities to insurers, particularly larger companies. - Consider a more risk-based allocation of supervisory resources to conduct of business work, e.g., include more explicit conduct-related issues in the risk classification system. ### ICP 10 — Preventive and Corrective Measures: Legal Powers and Practice - Unauthorized insurance business: - Statutory offence to conduct insurance activities without a license. (VAG2016 s331) - BaFin has powers to order discontinuation, winding-up, appoint a liquidator, and has powers of investigation and access. (VAG2016 s308) - BaFin required to apply principle of proportionality (VAG2016 s296). - Key BaFin powers (as stated in the law): - Restrict or prohibit disposal of assets when insurer has inadequate technical provisions (VAG2016 s133(1), (2)); and in circumstances when a recovery plan or financing plan are required (VAG2016 s134(7), s135(3)). - Take any action appropriate and necessary to remedy irregularities regarding insurer management or controllers. (VAG2016 s298) - Prevent insurer from entering new insurance contracts. (VAG2016 s300) - Require dismissal of persons leading the insurer or key tasks after due warning for willful or negligent breaches. (VAG2016 s303) - Appoint a special commissioner to take over management. (VAG2016 s307) - Revoke authorization where requirements no longer met or serious breaches occur. (VAG2016 s304) - Reject a reinsurance or retrocession agreement. (VAG2016 s298(3)) - Powers may apply to insurance holding companies and mixed financial holding companies. - Solvency control levels under 2016 legislation drawn from Solvency II: - Non-compliance with the SCR (or threat of non-compliance within three months) triggers immediate notification; where SCR breached, a recovery plan must be submitted within two months showing measures to restore compliance within six months (which may be extended to nine months). - Non-compliance with the MCR (or threat of non-compliance within three months) triggers immediate notification; where MCR breached, a finance scheme must be submitted within one month with measures to restore compliance within three months. Provision of an obviously inadequate finance scheme or failure to re-establish compliance with the MCR within three months are grounds for revocation of authorization. - Additional powers: - Require a financial recovery plan under pre-2016 VAG where insurer may be unable to fulfil liabilities in future (VAG s81b (2a)); this power is not reflected in EU Solvency II. - Impose a “capital add-on” increasing the SCR for individual insurers where risk profile deviates from assumptions or governance falls short (VAG2016 s301); impose add-on on a group or where group internal model risk profile deviates significantly (VAG2016 s264-5). - BaFin had no equivalent power under pre-2016 legislation (except linked to recovery plans) and does not expect to use the new capital add-on power except occasionally and as a last resort. - BaFin’s practical approach: - Graduated approach starting with informal exchanges with the company to confirm analysis; often issues resolved through dialogue. - Escalation to supervisory board as necessary. - Formal letters specifying powers and requiring corrective actions or imposing measures when breaches are established. - Recent use of powers: - Limited and focused on actual or potential breaches in financial requirements. - In the last three years BaFin asked three times for a financial recovery plan, twice for a solvency plan and three times for a financing plan under pre-2016 VAG, section 81b. - BaFin imposed restrictions on disposal of assets and writing of new contracts. - One small P&C insurer: supervisory escalation led to opening of insolvency proceedings in March 2015, initiated by BaFin. - Action taken to respond to deterioration in life insurers’ financial position due to low interest rates and Solvency II transition—focus on potential rather than actual breaches; exchanges with senior management and formal requirements where necessary. ### Comments and Recommendations on Preventive and Corrective Measures - BaFin has extensive powers and discretion with internal guidance supporting decision-taking and escalation. - Clear solvency control levels apply, ultimately leading to withdrawal of authorization. - BaFin monitors national accounting framework (national GAAP) for insolvency determination and should use the ORSA process to provide a clear basis for intervention before SCR is at risk. - Observed limited recourse to formal powers, particularly for qualitative requirements; formal powers used in financial weakness cases. - Reliance on exchanges with senior management is high; as Solvency II is implemented, BaFin should: - Consider its approach to intervention when insurer financial position deteriorates under national GAAP to ensure intervention reduces risk of insolvency on that measure. - As ORSA work develops, consider introducing a system of target minimum solvency requirements to be communicated to insurers based on ORSA review; develop internal policy framework for imposition and removal of formal capital add-ons using its legislative powers. - Continue to develop early and effective intervention across regulatory and supervisory issues, reflecting a more principles-based regime. ### ICP 12 — Winding-up and Exit from the Market; Insolvency Framework - Legislative framework spans supervisory legislation (VAG), insurance contracts law (VVG), and general insolvency law (Insolvenzordnung—InsO). - Exit options: - Insurer may renounce authorization; authorization also lapses if insurer ceases insurance business for six months. On renunciation or revocation, insurer prohibited from writing new business and from increasing or renewing existing policies; BaFin’s powers continue to apply. (VAG2016 s304) - Only BaFin can apply to the insolvency court to initiate insolvency proceedings; only court may open proceedings and appoint an administrator. Insolvent insurer must notify BaFin immediately. (VAG2016 s311-312) - Recent insolvency activity: - One insolvency of a small P&C insurer, started in March 2015. - Additional BaFin powers during impending insolvency: - Temporarily prohibit payments, including insurance benefits, profit distributions and, for life insurance, surrenders or policy loans or advances. (VAG2016 s314 (1)) - Reduce liabilities of a life insurer under insurance contracts in accordance with financial situation. (VAG2016 s314 (2)) - These powers may be exercised when audit findings show insurer will no longer be able permanently to meet liabilities and BaFin considers it in insureds’ best interest to avoid insolvency proceedings. (VAG2016 s314 (1)) ### Insurance Guarantee Schemes - Where insurer not able to meet liabilities and other measures insufficient, BaFin must order transfer of entire portfolio and associated assets to an insurance guarantee scheme if insurer is a member. (VAG2016 s222) - Two schemes: - Protektor (life insurance) - Medicator (private health insurance for substitutive health insurers) - Role of schemes: - Schemes run off insurance contracts and may seek to transfer them to other insurers. All life and health insurers must be a member of the relevant scheme. (VAG2016 s221) - BaFin supervises the schemes. (VAG2016 s1) - Financing and capacities: - Protektor: - Financed ex ante and has accumulated funds of EUR 897 million (1 per mille of the net technical provisions of all members). - Additional special contributions up to EUR 863 million can be levied, if necessary. - Beyond that point BaFin is required to use its powers to impose a 5 percent reduction of liabilities. - German life insurers have committed via separate private arrangements to provide additional funds up to a further 1 percent of net technical provisions (some EUR 9 billion at present). - Medicator: - Financed on an ex post basis. - A maximum of 2 per mille of members’ net technical provisions may be raised (EUR 388 million). - Motor vehicle liability insurance: - Guarantee scheme “Verkehrsopferhilfe” provides compensation where a person is injured or suffers damage in a car accident and BaFin has filed a petition for opening insolvency proceedings against the motor vehicle liability insurer. ### Protection of Guarantee Assets - Insurers must hold restricted assets in trust for policyholders (“guarantee assets”), making them effectively the highest class of creditors in insolvency. (VAG2016 s125-130) - Guarantee assets objective: enable insolvency administrator to meet claims of policyholders, beneficiaries, third parties, and premium refund claims (if contract cancelled/rescinded before opening of insolvency proceedings). - Guarantee assets must at least equal balance sheet values (or fair value, if lower) of relevant liabilities calculated under national GAAP. - Eligible assets per pre-Solvency II legislation; companies must select higher quality assets first when choosing guarantee assets. - Guarantee assets must be held within the EEA, managed separately, and recorded in a dedicated register. Insurer must appoint a trustee; trustee consent required for release of guarantee assets and joint custody arrangements apply. - These arrangements do not apply to reinsurance companies; no preferment of primary insurers’ claims in reinsurer insolvency. ### Point at Which Insurers Are No Longer Permitted to Operate - Conditions for revocation include breach of the minimum capital requirement and submission of an obviously inadequate financing plan or where BaFin considers insurer will not be able to fulfil the plan. (VAG2016 s304) ### Comments and Recommendations on Winding-up and Resolution - Wide range of powers and procedures enable prompt and orderly exit; BaFin can assess means to best serve insureds’ interests. - For life and health insurers, transfer to guarantee schemes likely to be the preferred route for small to medium-sized failures, assuming scheme capacity suffices. - Need to review guarantee scheme transfer procedures to handle complex portfolios (e.g., hedges using derivatives or reinsurance arrangements). - In P&C insurance, absence of a guarantee scheme (other than for motor third-party liability) exposes policyholders to potential reductions in liabilities imposed by BaFin or delays in claim settlement due to insolvency process. - Guarantee assets arrangements should generally provide for full recoveries and avoidance of loss. - For larger insurers and major reinsurance companies where guarantee scheme capacity is inadequate, arrangements need to be supplemented by resolution planning (work has begun for G-SIIs; see ICP26). - Recommendation: BaFin and the federal government should review whether granting BaFin the power to require a portfolio transfer to another (willing) insurer, in addition to transfers to guarantee schemes, would strengthen BaFin’s ability to address weak insurers. ### ICP 14 — Valuation (National GAAP and Solvency II) - Applicability: - Valuation for solvency purposes will be under Solvency II as implemented in Germany from January 2016. - Solvency II offers insurers a 16-year transitional arrangement expected to be used by many German life insurers. - Transitional measures phased out over 16 years; MCR and SCR without transition will not form binding constraints for most insurers in the short to medium term. - National GAAP remains important for dividends, policyholder allocations, and calculation of guarantee assets (ICP12). - National GAAP — Assets: - Principle of lower-of-cost-or-market; investments treated as current assets; temporary losses below acquisition price must be written down at balance-sheet date. - Exception: insurers may use cost basis accounting for a wide range of assets “if and to the extent that the assets held by insurers serve business operations on a permanent basis”; this treatment seems widely used. - Impairment recognized if lasting depreciation. Indicator for BaFin investigation: book value lower than market value by more than 10 percent. - Derivatives and securities lending transactions remain off-balance sheet; BaFin monitors both; BaFin does not have access to derivative transactions conducted within investment funds. - National GAAP — Liabilities: - Future discretionary benefits not explicitly included in insurance liabilities; some margins implicitly allow for future discretionary bonus payments. - Maximum technical interest rate and maximum zillmerisation rate set by Ministry of Finance: - Maximum technical interest rate reduced from 2.25 percent in 2011, to 1.75 percent in 2014 and to 1.25 percent in 2015 (Life Insurance Reform Act 2014). The maximum technical interest rate is used only for national GAAP (required for discounting new policies for valuation); Ministry of Finance is considering whether to abolish or reduce it from 2016. - Maximum zillmerisation rate reduced from 4 percent to 2.5 percent of total premiums (Life Insurance Reform Act); applies only for national GAAP. - Mortality tables published by German Actuarial Society; insurers may develop and use their own mortality tables (BaFin monitors off-site and on-site but does not approve). - Technical provision for P&C does not explicitly take into account time value of money. - Additional Interest Provisions (Zinszusatzreserve or ZZR): - Introduced from 2011: requires life insurers to hold a reserve for each policy that guarantees a return above the reference rate for expected asset returns; reserve equals interest rate shortfall expected over the following 15 years. - Reference rate: 10-year average of zero-coupon euro swap rates with duration of 10-year. - 2014: EUR 8.4 billion was made to ZZR, resulting in over EUR 20 billion on a cumulative basis at year-end 2014. - If reference rate increases, amounts reserved for policies whose guarantee rate is now lower than reference rate will be released. - If current low interest rates persist, life insurers are expected to be required to add to ZZR by more than EUR 10 billion annually from 2016 to 2018 and cumulative reserves will reach over EUR 70 billion. - Majority of reserves seem financed by selling assets to realize unrecognized gains on the asset side. - Valuation under Solvency II: - Assets: market-consistent valuation—amount at which assets may be exchanged between expert independent market participants. - Liabilities: value equals best estimate plus risk margin; best estimate is probability-weighted average of present values of future cash flows discounted using specified yield curve. - Yield curves and adjustments: - Yield curves provided by EIOPA referring to market rate up to 20 years; from 20 to 40 years extrapolation to the Ultimate Forward Rate (EIOPA set as 4.2 percent) beyond 60 years. - With BaFin approval insurers may use: - Matching adjustment for predictable liabilities cash-flow matched with fixed income assets, subject to conditions; insurers using matching adjustment must disclose two solvency ratios, with and without the adjustment. - Volatility adjustment to avoid pro-cyclical behavior when bond prices deteriorate due to low liquidity or exceptional credit spread expansion; calculated by EIOPA; insurers using volatility adjustment must disclose two solvency ratios, with and without the adjustment. - 16-year transitional arrangement allowed for technical provisions for contracts concluded before Solvency II start; insurers may use discount rates applied in December 2015; transitional measures phased out linearly. - Insurers using transitional arrangements must disclose two solvency ratios, with and without the transitional arrangement, and submit an annual report to BaFin describing measures necessary to meet SCR without transitional measures. - BaFin has power to limit the impact of transitional arrangements if application could lead to solvency requirements lower than requirements in national GAAP. - Comments and Recommendations on Valuation: - National Accounting: - ZZR should be amended in the medium term to encourage insurers to improve solvency via dividend reduction, cost cutting, and restructuring without relying mainly on recognizing unrealized gains and costly realization transactions. - Solvency II Valuation: - Further clarification needed on how BaFin will use powers regarding transitional arrangements. - BaFin should actively use its powers to maximize industry efforts to improve capital positions without waiting the full 16 years. - BaFin should develop a public communication strategy to address potential concerns over insurers’ soundness where transitional arrangements are used. ### ICP 15 — Investment Requirements and Controls - Post-Solvency II: - Investments eligible for covering technical provisions are regulated under section 54 of VAG. - Guarantee assets (must correspond to technical provisions under national GAAP) may be invested only in listed assets such as loans receivable, bonds and participation rights, real property, etc.; higher risk assets (non-investment grade bonds, private equities) may not be investable for guarantee assets. - After Solvency II implementation, quantitative investment requirements will be abolished and investment rules will move to a principles-based (prudent person) approach. Small insurers exempted from Solvency II will remain subject to quantitative investment requirements. - Investment funds: - Investment funds represented over 30 percent of total assets of insurers at end 2014. - Insurers must look through investment funds to comply with investment requirements; BaFin monitors asset allocation and investment mandates off-site and on-site. - Securities lending monitored and limited; BaFin cannot look through derivative exposures conducted within investment funds. - BaFin does not require insurers to account, for investment requirement purposes, for potential FX risks from investment funds whose AUM are denominated in Euro even if underlying assets are non-Euro. - Internal controls: - Circular 4/2011 “Guidance Notes on the Investment of Restricted Assets of Insurance Undertakings” sets risk management requirements. - Risk management must assess whether internal investment limits are appropriate and insurer’s ability to meet obligations sustainably. - Internal stress tests required at least quarterly. - Circular 4/2011 outlines minimum procedures: limits, authorizations, reporting of violations, independent price verification, updates of risk control procedures. - Reporting frequency specified: daily to head of investment management; monthly to management board and independent risk control function. Monthly reports must contain stress test results. - Security / Liquidity / Currency: - Speculative investments are prohibited; each investment must be disposable and transferable at all times as a general rule. - For fund investments: if a fund has more than 3 percent in assets lower than B- / B3, insurers must ensure those assets are sold or removed from the fund. - Insurers with adequate capital may invest in high-yield bonds at speculative grade B- or B3. - Entire investment portfolio must ensure liquid or easily realizable assets to meet essential operating liquidity; borrowing allowed only in exceptional cases. - VAG requires at least 80 percent of investments be denominated in the currency in which liabilities must be settled. *Source: IMF Financial Sector Assessment Program extract (2016) provided in the content unit.* ### Section 3 (2) to (6) of the Investment Regulation (AnIV) contains special minimum ### _cr16192 - Section 3 (2) to (6) of the Investment Regulation (AnIV) contains special minimum ### Investment Regulation: special minimum diversification requirements - Loans to German governments, EEA and OECD countries, etc.: 30 percent, but it excludes security investment. - Certain debt instruments: 15 percent limit. - Investments into land: 10 percent - All investments in a single issuer: 5 percent - Directly or indirectly held portion of high-yield bonds: 5 percent - AnIV Section 4 stipulates that equity investments in one entity should not exceed 1 percent of the restricted assets. ### Complex and less transparent asset classes — specific circulars and limits - Asset-backed securities and credit linked notes should not exceed 7.5 percent of the guaranteed and other restricted assets. - Hedge funds and funds linked to commodity risks may not exceed 7.5 percent of the guaranteed and other restricted assets. - Loans to foreign institutions may not exceed 5 percent of guaranteed and other restricted assets. - Equity investments (including some subordinated debt investments) may not exceed 35 percent of the guaranteed and other restricted assets. - Circular 1/2002 addresses asset-backed securities; circular 7/2004 addresses hedge funds. ### Observations on permitted operations and potential risks - Circular 3/2000 seems to allow yield enhancing operations with a wide range of options (short call, IR and FX swaps, etc.). - While Solvency II implementation will discourage insurers from investing in risky assets because of the need for adequate capital, there is a risk that insurers using the standardized SCR approaches may take risks which are not captured in Solvency II capital requirements, such as sovereign bonds and illiquid assets. - Moving from a rules-based to a principles-based approach to investment regulation will be challenging, both for supervisors and insurers. ### Policy recommendations on supervision and coordination - BaFin supervisors should implement planned investment analysis by peer comparison of investment limits. - BaFin supervisors should hold discussions about risk tolerance statements. - BaFin supervisors should actively challenge investment decisions, making investment a priority focus for supervision in the early days of Solvency II implementation. - Insurance supervisors should continue to coordinate with securities supervisors to monitor derivatives activities used by investment funds, given the significant share of investment allocation by insurers and potential risk of excessive leverage through investment funds. ### ICP 17 — Capital Adequacy (Solvency II application and scope) - Solvency II will be applied to insurers except small insurers which meet certain criteria (such as EUR 5 million gross written premium incomes and EUR 25 million of technical provisions, etc.). - About 90 percent of insurers will be subject to Solvency II from January 2016. - While Solvency I requirements will continue to apply to small insurers, given the wide coverage of Solvency II implementation from January 2016, the description focuses on capital adequacy requirements under Solvency II. ### Total Balance Sheet Approach - Solvency II provides for a consistent and economic measurement of assets and liabilities and explicit identification and consistent measurement of risks and their potential impact on material components of the balance sheet. - This is reflected in the German implementing legislation. ### Target criteria: SCR and MCR - Solvency II has two levels of regulatory capital requirements, Solvency Capital Requirements (SCR) and Minimum Capital Requirements (MCR). - SCR is calibrated to correspond to the Value-at-Risk with a confidence level of 99.5 percent over a one-year period and several methods are allowed (including a standard formula, partial and full internal models). - MCR is based on a simple formula and subject to a floor (25 percent) and cap (45 percent) of SCR. - SCR and MCR need to be calculated at least annually and quarterly respectively. ### Risk factors and diversification treatment - Solvency II covers a wide range of risk factors, including market risk, counterparty default risk, underwriting risk and operational risk. - Market risk also covers comprehensive risks, including ALM, equity, property, spread (bonds), credit derivatives, etc. - Underwriting risk covers risks including longevity, lapse and catastrophe risks. - In the standardized approach, a prescribed correlation matrix is used to recognize diversification benefits twice, within market risk and overall SCR calculations. ### Solvency control levels and remedial timeframes - Under Solvency II, the law will no longer provide for BaFin to require an explicit recovery plan at levels above the SCR. However, insurers have to assess their ability to meet regulatory capital requirements at all times going forward as part of the Own Risk and Solvency Assessment (ORSA). - Insurers have to report the ORSA result to BaFin within two weeks of completion of the ORSA. - Submission of a recovery plan or a finance scheme in case of non-compliance with the SCR and MCR will be mandatory within a certain period (two months for SCR and one month for MCR). - Timeframes for remedial measures are also prescribed. - Compliance with the SCR needs to be re-established within six months or a maximum of nine months where BaFin grants an extension. - Compliance with the MCR has to be re-established within three months. - There are no prescribed consequences where an undertaking fails to comply with the SCR again at the end of the recovery period, but BaFin would decide on short term measures which the insurer would have to introduce to re-establish compliance with the SCR. - If an insurer were unable to re-establish compliance with the MCR within three months, it would be mandatory for BaFin to withdraw the authorization of the insurer (see also ICP10). ### Variation of capital requirements - Variation of Capital Requirements *Source: _cr16192 - Section 3 (2) to (6) of the Investment Regulation (AnIV) contains special minimum* ### Section 301 of the VAG stipulates the conditions where BaFin can increase the SCR and ### Section 301 of the VAG and BaFin’s Supervisory Framework ### Capital add-ons under Section 301 (VAG) - Conditions for BaFin to increase the SCR include when internal models are under development and when insurers use LTG measures. - The capital add-on must be proportionate to the deficiency. - BaFin must review any capital add-on annually. - Capital add-ons are to be used as temporary measures. - One circumstance where a capital add-on could remain in place for some time: - 1) an insurer uses the standard formula; - 2) the formula does not adequately reflect its risk profile; - 3) the insurer cannot be required to develop an appropriate internal model. ### Adjustment of capital requirements and loss-absorption capacity - Majority of life insurance products include policyholder profit participation with a minimum return guarantee. - German insurers have wide discretion to reduce the bonus in case of lower investment performance, adverse loss realization, or higher-than-expected costs. - After Life Insurance Reform Act 2014 (LIRA), life insurers can: - offset investment losses with gains from the risk and expense components of return; and - assume higher loss absorption capacity in stressed situations. - Solvency II (standardized approach and internal models) allows recognition of such loss absorption capacity and deduction from capital requirements subject to a cap determined by the amount of future discretionary bonus embedded into the technical provision. - BaFin guidance: - surplus fund for Solvency II purposes and future discretionary bonus are adjusted to avoid double counting of loss absorption capacity; - insurers must calculate provisions for future discretionary bonus without taking into account future bonus payments arising from surplus funds. - Reporting under preparatory arrangements: as of the end 2014, future discretionary bonus is about 4.6 times larger than surplus funds. ### Internal models: approval, validation, and use - Use of an internal model on a full or partial basis is allowed upon approval of BaFin. - BaFin’s validation requirements include: - a statistical quality test (conducted through intense onsite inspections, e.g., sampling single contracts to check correct mapping to risk factors and requiring recalibration); - a use test (insurers must use the model not only for pricing but also for compensation schemes for managers); - documentation requirements (BaFin has required significant improvements over the preparation period). - Insurers approved to use internal models are required to set aside capital for sovereign exposures (not required for spread and concentration risk under the standardized approach, although required for interest rate risk). - BaFin reports that only a handful of insurers will be finally using internal models from 2016 and some of them are not using a full internal model. ### Capital resources, tiers, and volatility adjustment - Solvency II allows a wide range of capital instruments as capital resources, including Tier 2 and Tier 3 with certain limits. - The sum of Tier 2 and Tier 3 cannot exceed 50 percent of the SCR. - In practice, Tier 1 capital will form a majority of capital resources in German insurers. - QRT survey among life insurers submitted at the end of 2014 (not representative for all German insurers): 97 percent of the capital resources come from Tier 1 instruments (such as Surplus Funds and Reconciliation Reserves). - Volatility adjustment: - Upon BaFin’s approval, insurers can use the volatility adjustment to avoid pro-cyclical investment behavior when bond prices deteriorate due to low liquidity or exceptional expansion of credit spreads. - The adjustment stabilizes capital resources and will be set by EIOPA. - Insurers using volatility adjustments must disclose two solvency ratios, with and without the adjustment. - Capital resources derived from the volatility adjustment may not fully meet ICP quality and suitability criteria (availability and permanence); insurers using it must demonstrate ongoing compliance via ORSA. - The amount of capital resources from the volatility adjustment will be immaterial under normal market conditions where spreads are not exaggerated. ### Tier 1 components - Surplus funds (RfB) are recognized as Tier 1 capital: amount set aside for policyholders for future dividends where insurer has discretion on allocation and timing. - Excess of assets over liabilities under Solvency II valuation is recognized as Reconciliation Reserves and forms part of Tier 1. - Guidance provided to avoid double counting of loss absorption capacity into both surplus fund and Loss Absorption Capacity. ### BaFin’s supervisory recommendations on models and capital - Comments and recommendations: - BaFin has made significant efforts to validate internal models; it is recommended BaFin continue to devote resources to on-going validation and require insurers to improve their internal models. - Because some Solvency II standardized approach components depend significantly on company assumptions (e.g., interest rate risks and loss absorption capacity), it is recommended BaFin use analysis developed through internal model validations to assess the SCR under the standardized approach (for example assumptions on policyholder dividend reduction or of taxable income for deferred tax). - If the majority of German insurers plan to use the volatility adjustment, BaFin should consider encouraging them to build up capital resources during periods of stable volatility through the ORSA process so that volatility adjustment is used solely for countercyclical purposes. ### Conduct of Business (ICP 19): framework and findings - BaFin’s supervisory objectives include conduct of business to protect policyholders and beneficiaries; legal responsibility to ensure interests of the insured applies only to primary insurers (VAG2016 s294); reinsurers are in practice not subject to treatment-of-policyholders requirements. - Ministries of Justice and of Health and Social Affairs handle financial consumer protection regulations. - Insurance intermediaries licensed/supervised by German Chambers of Industry and Commerce under the 2007 Insurance Mediation Law (VersVermG); BaFin has indirect regulatory role via insurer requirements and circular 10/2014 (VA) on cooperation with intermediaries. - Conduct requirements and consumer protections: - Disclosure requirements under Ordinance on Information Obligations for Insurance Contracts (VVG-InfoV): product information document; withdrawal rights; ongoing advice (VVG s4). - Suitability and needs-based advice requirements when selling products (VVG s6 (1), 61 (1)); customers can claim damages for inappropriate advice. - Intermediary must inform customer of status at first contact. - Life and health insurers must inform customers about costs of concluding a contract (VVG-InfoV, s2); main part is remuneration which need not be disclosed explicitly. - Promotion and forbidden sales practices governed by Act against unfair competition (UWG). - Special requirements during contract lifetime in VVG-InfoV s6 (4). - Annual statement to policyholders about profit participation for life contracts. - Contractual changes must be communicated and sometimes give cancellation right (VVG s40). - Insurers must have reliable policies/procedures to handle claims timely and fairly. - BaFin’s consumer complaints handling: - Dedicated unit handles complaints; unresolved matters referred to ombudsman or courts. - Most insurers recognize one of two ombudsmen (health and all other sectors); ombudsman reports publicly at least annually. - BaFin publishes data about complaints handling in its annual report and information via BaFin-Journal. - Conduct-related recommendations: - Reconsider limitation of conduct of business requirements to primary insurers. - BaFin should review whether it can reduce volume of individual customer complaints it handles by ensuring complaints are directed to ombudsman services. ### Macroprudential Surveillance and supervision (ICP 24) - BaFin identifies, monitors, and analyses market and financial developments drawing on: - supervisory reporting by insurers; - analysis by domestic and international authorities (Bundesbank, European Systemic Risk Board, EIOPA) via the Financial Stability Committee (FSC) process; - public information (financial reporting, market indicators). - Organizational roles: - Insurance directorate (Research and Financial Stability) performs insurance-specific analysis and maintains a list of current risks. - Analysis and Strategy central department manages broader market/economic analysis and BaFin’s Risk Committee inputs. - Key public reporting has focused on low interest rate risks to life insurers, including role of Additional Interest Provision (Zinszusatzreserve) and need for new products suitable to low rate environment. - Horizontal review tools: - Regular stress tests since 2004 on life, health, and P&C companies (not reinsurance); expanded recently for life insurance with an annual projection requirement and a five years horizon. - Regular ad-hoc surveys of insurer samples on exposures, lines of business, and product impacts. - BaFin carried out two quantitative-impact surveys on new Solvency II requirements for life insurers as at end-2013 and end-2014; summaries were published and used to support supervisory work. - Coordination with other authorities: - Macroprudential responsibilities shared in FSC: Bundesbank monitors mainly life insurance and is invited to BaFin’s Risk Committee; BMF is executive authority responsible for regulatory process (e.g., Additional Interest Provision and Life Insurance Reform Act of 2014). - FSC issues warnings and recommendations to prevent financial stability risks. - Systemic importance and group supervision: - BaFin is group-wide supervisor for one G-SII and co-operates as host supervisor for two others (and one former G-SII). - BaFin restructured supervisory teams in 2015 to concentrate supervision of major international groups and developed risk classification to include a "Very High" category. - BaFin has implemented IAIS elements for G-SII supervision including requiring a Systemic Risk Management Plan (SRMP), Liquidity Risk Management Plan (LRMP), and establishment of a CMG. - Macroprudential recommendations: - AFS and government consider giving AFS more scope to take macroprudential action without legislative change. - BaFin consider applying macroprudential tools (e.g., regular stress tests, recovery and resolution planning) to larger reinsurers. - Develop plans for implementation of IAIS higher loss-absorbency capacity (HLA) for G-SIIs to avoid legal or policy obstacles. ### Supervisory cooperation and colleges (ICP 25) - Legal/policy framework: - Cross-border cooperation via supervisory colleges is long-standing and transitioned to Solvency II emphasis on group supervision (VAG2016 s278). - April 2015 law changes empowered BaFin to establish colleges and share information and cooperate on internal model approval. - From January 1, 2016, colleges are mandatory for each EU group with cross-border activities; binding decisions can be taken by the group supervisor or college members. - Group supervisor responsibilities include coordination of information gathering, supervisory review of group financial situation, assessment of solvency compliance, governance assessment, and coordination of supervisory activities including in an emergency. - Coordination arrangements and confidentiality provisions to be established by group supervisor (VAG2016 s283(4)); EIOPA Guidelines on operational functioning of colleges (2014) provide standard formats. - Practice: - BaFin is group supervisor for 17 insurance groups and a college member for another 14; aims to conclude coordination arrangements by end of 2015. - Two-tiered college approach (EU college and global college) in principle; formats include global college, EU only, and EU internal model college; CMGs evolving as core college format for G-SIIs. - Non-EEA supervisors may become college members if confidentiality criteria met; BaFin maintains a list of assessed countries. - Priority work in colleges: establish communication channels, map group legal entity structure, and develop overall risk overview; internal model approval has been a major focus. - Comments: - BaFin invested significantly in college arrangements and groupwide supervision, benefiting from and contributing to EIOPA frameworks. - Remaining challenge: agreeing risk assessments for each group and using these to inform group-wide supervisory coordination. ### Cross-border crisis management, recovery and resolution (ICP 26) - Focus and current state: - BaFin’s main crisis-management focus is EU cooperation via colleges and G-SII-specific recovery/resolution planning. - No EU framework yet for insurer recovery and resolution; limited insurance-specific provisions in German law; no resolution authority for insurers in Germany. - BaFin’s work on G-SIIs has been largely voluntary. - Preparedness and emergency plans: - Colleges cover crisis preparedness per EIOPA guidelines (Emergency Plan): exchange of confidential information, group structure transparency, early crisis alert, and secured information flow. - Group supervisor is responsible for preparing Emergency Plans as annex to coordination arrangements. - BaFin developing emergency plans based on EIOPA guideline and planned to complete coordination arrangements for colleges by end of 2015. - BaFin capabilities and expectations: - No explicit legal requirements on insurers to supply timely crisis information or maintain contingency plans (except business interruption planning); BaFin places expectations on insurers via risk management requirements. - BaFin established CMGs for the G-SII for which it is group supervisor and participates in CMGs for others; CMGs focus on crisis preparedness including recovery and resolution planning. - Recovery and resolution planning: - BaFin may require insurers to prepare “general recovery plans” (VAG2016 s26 & s34) but has not formally exercised these powers; recovery planning is being undertaken with G-SIIs. - BaFin has extensive powers to act in a crisis but no explicit legal requirement on insurers for resolution planning; has powers to obtain information usable for resolution planning. - For financial conglomerates, law requires contribution to recovery and resolution procedures when necessary (FKAG, s25); powers not yet used. - CMGs for groups BaFin supervises are preparing resolution plans taking the FSB Key Attributes and Annex 2 on insurer resolution into account; these are at an early stage. - Comments and recommendations: - BaFin has been implementing crisis management arrangements via colleges; recovery and resolution planning currently confined to G-SIIs with BaFin acting de facto as resolution authority. - Recommended actions: - BaFin use its powers to require significant insurers to develop recovery plans, starting with higher risk insurers under the risk classification system and considering Solvency II implementation priorities. - Consider application of recovery and resolution planning to all larger groups (not only G-SIIs), reflecting scale and global importance and FSB expectations. - Fill gaps in regulatory framework regarding requirements for companies to be ready to report necessary information in a crisis and to maintain contingency plans. *Source: _cr16192 - Section 301 of the VAG stipulates the conditions where BaFin can increase the SCR and* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16192.pdf_