The guaranteed rate for German life insurance contracts is currently 1.75 per cent, but has been as high as 4 per cent over the last 12 years. Typically, the reserves for a contract are calculated by discounting the expected cashflows at the guaranteed rate.
However, accounting rules require German insurers to hold an additional reserve, the Zinszusatzreserve (ZZR), if the reference rate for expected asset returns drops below the contract guarantee level. The reference rate is the rolling 10-year average of the European Central Bank (ECB) AAA 10-year rate. In 2011, this average fell below 4 per cent, forcing insurers to hold additional reserves for the first time for the next 15 years of cashflows.
With the current ECB AAA 10-year rate at 1.99 per cent, the reference rate average will continue to decline in the coming years unless interest rates increase rapidly. German insurers need to negate the income statement impact of future ZZR increases, while preserving a competitive book yield on their asset portfolio.
RBS has helped German insurance clients by using scenario analysis of the development of the reference rate to structure two types of solution:
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Buy in-the-money downside rate protection - involves buying downside protection through constant maturity swap floors/receiver swaptions embedded in a fixed-income instrument, to be held at book value. However, the hedging cost would significantly reduce the book yield and the hedging size would be extremely large.
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Utilise unrealised gains in the asset portfolio to fund protection against interest rate rises. Payer swaption spreads protect unrealised gains against rate increases up to the level where the reference rate begins to increase. Using spread strategies cheapens the hedging cost relative to standard payer swaptions.
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