German Insurers Pursue Underwriting Profits As Low Interest Rates Bite

Primary Credit Analyst: Christian Badorff, Frankfurt (49) 69-33-999-199; christian.badorff@standardandpoors.com Secondary Contact: Ralf Bender, CFA, Frankfurt (49) 69-33-999-194; ralf.bender@standardandpoors.com Research Contributor: Robert Avila, Frankfurt (49) 69-33-999-189; robert.avila@standardandpoors.com

Table Of Contents
Diverging Dynamics Determine Insurers' Financial Strength A Sound Economic Environment, But Interest Rates Will Stay Low New Investment Strategies Aim To Offset Low Interest Rates Life Insurance: Low Yields Are The Main Pressure Point Property-Casualty: Sound Medium-Term Prospects, Despite Short-Term Pressure From Natural Catastrophes Health Insurers: Competitive Weakness And Political Uncertainty Pose Risks Capitalization Will Hover Broadly In Line With Current Ratings Solvency II Implementation By 2016 Will Burden Insurers Continued Low Interest Rates Portend Challenges Ahead Related Criteria And Research

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Insurance companies we rate in Germany are still proving fairly resilient to the low interest rate environment, and we expect this situation to continue over the coming 12-24 months, as our mostly stable outlooks reflect. Still, their leeway to offset low yields is gradually tightening and, in our view this will call for continued efforts to strengthen underwriting returns. Over the long run, we see a risk that not all life insurers in Germany will be able to withstand continuing low interest rates and finance additional technical reserves alongside policyholder guarantees under current profit-sharing rules. Added to this, the effects of the exceptional natural catastrophes that property-casualty insurers suffered in Germany in 2013, additional burdens to comply with the EU's forthcoming Solvency II framework, and uncertainties over the political agenda for health and life insurers could weigh on insurance companies' business and financial risk profiles over the coming year. Our average rating on German insurers, including Germany-based subsidiaries of international groups, is in the 'A' range. Property-casualty insurer ratings are supported by improving underlying underwriting earnings and strong capital adequacy. The ratings on life insurers and health insurers, however, may come under more accentuated pressure as low interest rates continue to strain their competitive position, prospective capital, and earnings. Our ratings on some of these insurers assume that they would receive full financial support from the larger groups to which they belong, if necessary. We have therefore assigned "intermediate" insurance industry and country risk assessments for the life and health sectors, while we see "low" risk for the property-casualty sector (for further details see "Related Research" at the end of this report). Overview Low Interest rates will continue to weigh on German insurers' investment returns, in spite of some expected recovery of rates over 2013-2015 in our base-case scenario. Life insurers could suffer weaker competitive positions, earnings, and capital adequacy prospects from the low interest rate environment, in spite of management strategies to try to stabilize financial strength. We expect property-casualty insurers to be better placed to offset low yields by improving underwriting profits in 2014-2015, while health insurers are also facing political headwinds. We anticipate that German insurers' risk-bearing capacity will diverge further as the flexibility of weaker players shrinks. The EU's recent decision to implement Solvency II regulations by 2016 will likely burden insurers' efforts to adapt their product portfolios, economic pricing, and capital management.

Diverging Dynamics Determine Insurers' Financial Strength

Both positive and negative factors are influencing the financial strength of the three German insurance sectors. While German property-casualty insurers will likely experience a drop in underwriting profits after several natural catastrophes (floods, storms) in 2013, they are implementing rate increases and improving claims management. This

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should help offset decreasing investment returns, and could support a further improvement in earnings and support already strong capitalization. For life insurers, lower investment returns resulting from low yields are not only reducing earnings and capital adequacy, but are also constraining the attractiveness of retirement saving for customers and thus reducing the sector's growth prospects. Selected malpractices and negative attention from customer lobbyists and the media are amplifying this difficulty. A moderate increase in interest rates, which we expect in our base case, would however only very gradually result in recovering earnings for life insurers. This is because the need to build capital in anticipation of Solvency II and the additional technical reserves build-up are also depressing their earnings. In the case of health insurers, low interest rates are predominantly weighing on their competitive position. Premium rises are helping companies secure relatively stable earnings and capital adequacy, but they may make comprehensive health insurance, the sector's most important product, less attractive to customers. Health insurers also face pronounced political risk given the ongoing discussions about the future of Germany's dual health insurance system, comprising private and statutory health insurers. The recovery in interest rates we've observed over 2013, and which we expect to continue in 2014 and 2015 under our base-case scenario, should somewhat support German insurers' financial strength, but will not be sufficient to significantly improve the outlook for the German life insurance sector, in our view. This would require substantial progress in reducing the guarantee risk exposures in the back book and more diverse earnings streams to lessen their vulnerability to low interest rates. Prospects for a more positive outlook for health insurers are also unlikely as long as the current political risks to the sector do not abide. Any deterioration in financial market conditions over the coming months, characterized by falling bond yields, asset quality deterioration, or equity market decline, could trigger less favorable conditions for all three sectors, particularly life insurance. In general, should earnings and capital adequacy trend weaker than we currently anticipate, this could also herald a more negative outlook. The diverging dynamics facing the three sectors will not necessarily result in corresponding rating actions. Even in a difficult market environment, some companies are able to withstand the difficulties or even disassociate themselves from negative market sentiment. What's more, our ratings on insurance companies that are part of a larger group take into consideration the extent to which they contribute to the business and financial risk profile of the group, resulting in the assignment of a group status. Many insurance groups in Germany that operate in two or more insurance sectors are therefore able to compensate less favorable trends in life or health insurance with typically more favorable trends in property-casualty. Some of our ratings on life and health insurers are therefore based on our assumption that a larger group will be able and willing to provide support, if need be.

A Sound Economic Environment, But Interest Rates Will Stay Low

German insurers are generally benefitting from a domestic economic environment that is more favorable than most other European countries, both in terms of GDP growth and unemployment rates. For 2013, Standard & Poor's economists forecast real GDP growth of 0.5% (see table 1), which although modest is still stronger than the -0.7% for

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the eurozone (European Economic and Monetary Union) overall. We expect unemployment in Germany to slide further in 2013, to 5.4% from 5.5% in 2012, and this should be followed by further decreases to 5.1% by 2015. Strong economic activity, low unemployment rates, and growing customer confidence have also resulted in increased customer spending, which we expect to continue through 2013-2015. These factors in principal support stable or growing demand for property-casualty (P&C), life, and health insurance products. The flip side of a very resilient German economy, however, is that domestic bond yields continue to be very low. Ten-year German Bund yields reached an all-time low in May 2013, at about 1.2%. Since then, we have seen a marked recovery in yields by as much as 80 bps, to about 2.0% in September 2013 (see chart 1). Bond yields nevertheless remain low compared to historic levels. Our economists expect interest rates to increase slightly but steadily over 2013-2015, and this forms the base-case scenario for our ratings. Yet, despite our latest interest rate forecast, the recent European Central Bank (ECB) decision to lower its main refinancing rate to 0.25% from 0.5% signals that insurers should generally prepare for continued policymaker influence to maintain a low yield environment.
Chart 1

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Table 1

Germany Selected Economic Indicators

2012 GDP growth (% change from a year earlier) Unemployment rate (%) CPI inflation (% change from a year earlier) 10-year bond yield (year-end) (%) f--Forecast. 0.7 5,5 2.1 1.5 2013f 0.5 5.4 1.6 1.8 2014f 1.8 5.2 1.8 2.3 2015f 1.7 5.1 1.7 2.8

Equity markets generally have been favorable across Europe in 2013, especially in Germany. Equity indices that had suffered the most since the outbreak of the financial crisis managed to recover some of the losses and showed an impressive performance. All in all, 2013 so far has been a good year for equity investors (see chart 2).
Chart 2

New Investment Strategies Aim To Offset Low Interest Rates

German insurers continue to adhere to relatively conservative investment strategies that result in low income and balance-sheet volatility, but increase their sensitivity to the development of interest rates. Asset-liability mismatches

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dominate risks, in particular for life and health insurers. We also observe that insurers are diversifing their asset allocations to weather low yields in line with individual risk-bearing capacities. They are opting for different combinations of credit, equity, property, or alternative investments to supplement their typically high-quality bond portfolios. The low yield environment has created massive asset value reserves in German insurers' bond portfolios, although these are temporary and volatile in nature because insurers typically hold investments to maturity. These asset value reserves stood above 60 billion at half-year 2013 after a peak at about 90 billion during 2012, versus just 3 billion in the first quarter of 2011, according to the German Insurance Association (Gesamtverband der Deutschen Versicherungswirtschaft, GDV). They have already declined somewhat from their peak following the recent interest rate recovery. Some life insurers have already partly realized such reserves to build additional technical reserves ("Zinszusatzreserve") or to cope with the participation of maturing or lapsing policyholders in asset value reserves. The trend toward prolonging asset durations came to a halt during 2012/2013, according to our analysis, in the wake of low yields, uncertainty surrounding the Solvency II start date, and the controversy over asset value reserve sharing with maturing or lapsing policyholders. If these uncertainties disappear over the next months, and the yield curve remains reasonably steep, we could envisage life insurers returning to lengthening asset durations and reducing their asset-liability mismatches in the wake of Solvency II implementation. The significant volatility in interest rates during 2013 makes it difficult to express an average rate for new and reinvestments for the industry. This is because it will have made a huge difference whether the bulk of investment occurred at the beginning of the year when yields were relatively low, or in the second half of the year that saw much higher yields. Furthermore, insurers have taken different approaches to credit risk to sustain a more stable coupon yield. Since 2007, insurers have reduced their exposure to riskier asset classes (see chart 3). For insurers we rate, fixed-income investments comprised 90% of their asset base in 2012. Companies continued to maintain low equity exposures, which accounted for 4% of total invested assets. Property exposures also remain low, at 5%, although insurers often emphasize their willingness to increase their exposure in this asset class.

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Chart 3

Credit risk is still moderate, but has increased due both to rating migration and insurers' active asset management. The credit quality of some existing investments has worsened in 2013, particularly in Southern Europe. Furthermore, insurers' portfolios are still somewhat concentrated in bank investments. The trend toward replacing maturing government or covered bonds with corporate bonds adds to growing credit risk exposures, in our view. To offset fundamentally low interest rates, insurers are increasingly looking for higher yielding bond investments with the consequence that credit quality is somewhat lower. As a result, bonds rated at least 'A' made up about 84% of the aggregate portfolio at year-end 2012, down from 93% at year-end 2008 (see chart 4).

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Chart 4

In aggregate, we don't expect to see material swings in asset allocation over 2013-2015. We expect that fixed-income instruments will remain by far the main asset class. The majority of insurers are refraining from materially increasing investments in equities in view of high capital requirements for this asset class under Solvency II. Some companies, however, are gradually increasing their equity exposures to attain higher returns, while trying to protect their profit-and-loss statements and their balance sheets by employing dynamic exposure steering and hedging. Many insurers also appear to see other real-value investments, such as in property or infrastructure, as attractive. Currently, however, we do not anticipate that they will extend these significantly over the short to medium term. One reason for this is the difficulty in finding attractive investment opportunities given that demand for these investments has risen recently.

Life Insurance: Low Yields Are The Main Pressure Point

For Germany's life insurers, low yields are eroding the spread between investment returns and guaranteed rates they pay to policyholders. This is reducing earnings' prospects for policyholders in terms of bonuses on top of guarantees, and for shareholders. It is therefore weighing on companies' competitive positions, earnings, and capital adequacy. Added to this, the industry has come under close scrutiny from customers, consumer lobbyists, and the media. We

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believe this is mostly a consequence of lower returns distributed to various stakeholders. But it is amplified by consistently high distribution costs despite declining gross surpluses and a series of malpractices that have surfaced over the past few years. These difficulties are overshadowing an otherwise favorable outlook on long-term life insurance demand given the benefits that life insurance can offer an aging population.

Leeway for offsetting the low yield environment is tightening

Companies have pulled several levers to reduce their vulnerability to low yields in recent years. The most significant include: Building additional technical reserves of almost 13 billion by year-end 2013 to effectively lower guarantee commitments; Adjusting investment strategies; Reducing policyholder bonuses in line with declining investment yields; Shifting new business away from traditional guarantees; and Improving risk results and cost efficiency. Some measures provide fairly immediate support, such as the creation of additional technical reserves at the expense of current policyholder payments. These were imposed by the German government to better prepare German life insurers for a potential long-term low interest rate environment. To finance these additional technical reserves, life insurers have realized asset value reserves and cut annual policyholder bonuses over recent years. Although we expect companies to further reduce bonus rates for 2014, we recognize they likely will have to manage an increasing imbalance between the returns to policyholders at old high guarantees and lower returns on younger generations of traditional products. Other strategies to offset low yields, in particular a strengthening of risk results or a change in the inforce book composition through new business shifts, will take years or decades to achieve any meaningful impact. The industry has already come a long way in reducing administrative expenses, although further efforts may be enforced by competitive pressures and low yields.

Some rated life insurers are more vulnerable to low yields and more dependent on investment results than others
We predominantly examine two factors when assessing the impact of a sustained low-yield environment on a rated insurer: the immediate vulnerability of investment returns to low yields, and their overall dependence on investment results. The vulnerability to low yields generally is low for insurers with still comparably high investment returns, strong risk and cost results, superior investment and duration management, and strong capital buffers on the balance sheet. The dependence on investment results depends on the significance of traditional guaranteed business and, again, cost and risk results. Among the German life insurers we rate, such low-yield vulnerabilities and investment-result dependencies diverge widely. Based on our projections of gross surplus trends for the life insurers we rate, we expect that these companies will be able to meet their policyholder guarantees at the very least over our projection period of seven years under our base-case scenario. A protracted low yield environment, however, may put a strain on some industry participants. Nonetheless, we believe that the subset of companies we rate is a positive selection of the entire German life insurance sector that demonstrates above-average financial strength. In very adverse yield scenarios, this might require the

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financial backing of their respective parent groups for some life insurers, which we incorporate in our ratings as part of our group rating methodology.

Companies have so far hardly adjusted distribution costs to lower surplus generation
Insurers have protected distribution costs for many years. Declining gross surpluses coupled with broadly stable distribution costs have substantially increased the share that distribution forces receive from available gross revenues. What's more, we believe there is material excess capacity of sales representatives across the country. While life insurers might not perceive their risk-adjusted returns as adequate, life insurance sales remain important in helping many German insurers finance their distribution channels.

Reputational challenges are overshadowing long-term growth opportunities

Demographic change and likely declining statutory pensions should, in principle, provide healthy long-term growth opportunities for German life insurers, in our view. Nevertheless, insures will have to find new products with manageable risk capital consumption, reduce their distribution costs, and strengthen the industry's reputation again. Continued annual bonus reductions could increasingly lead existing customers to question the attractiveness of traditional life products, in our view. This will likely lead to only stagnating premium volumes in 2013 and beyond, unless the industry can launch attractive new savings products and transport the value of risk products, such as term-life and disability insurance, to the consumer. While insurers have launched new product types in recent years, they have so far failed to widely convince consumers of their attractiveness (see chart 5). More recent attempts by leading life insurers to offer products that are less interest rate-sensitive, with lower or no guarantees, underline the industry's attempts to innovate. We believe the trick will be to explain products with complex structures in simple terms to potential customers, or create relatively simple products.

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Chart 5

A sharp rise in interest rates, although unlikely in our view, could also threaten the attractiveness of life insurance products. Whereas the prolonged duration of life insurers' fixed-income investments has proven beneficial in the present low yield environment, it does not allow companies to quickly benefit from such a scenario. It would therefore take time for bonus rates to catch up with higher market yields, whereas bank deposit and investment fund returns could increase faster. It is nevertheless difficult to anticipate how steep such an interest rate increase would need to be to significantly increase the currently low surrender rates. Our base-case scenario, however, foresees only moderately increasing interest rates over 2013-2015, reaching 10-year bund yields of about 2.8% by 2015, which in our view are unlikely to result in strongly growing surrenders.

A fast recovery of profitability is unlikely

Two factors are influencing German life insurers' earnings: Additional reserving requirements imposed by the government in the face of low interest rates; and Regulations forcing companies to pay out 50% of existing asset value reserves to policyholders with maturing or cancelled contracts, regardless of whether these reserves are sustainable or not. These two factors forced many companies in 2012 to make use of realized gains on fixed-income investments to bolster their reported total investment returns (see chart 6). By contrast, the net investment return, measuring the

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current yield, has decreased quite considerably on average over the past five years to about 4.1 % in 2012 from about 5.0% in 2007, based on our estimates.
Chart 6

Over the same period, the sector's average guaranteed rate in the back book has only very gradually decreased, and currently stands at about 3.0% in relation to total invested assets, by our estimates. Although companies have reduced their annual bonuses considerably, they still suffer from a compression of the spread between sustainable investment returns on the one hand and guaranteed rates and bonuses on the other. This has also put a strain on free bonus reserves. We anticipate the following trends: Average running investment yield will be below 4.0%, whereas net investment yields will continue to benefit from realized gains at around 4.5%. Additional reserving requirements will add up to about 6 billion in 2013. This is because 3.5% guaranteed rates in the back book will require reserve strengthening. The guaranteed rate excluding the impact of reserve strengthening will decrease by between five and 10 basis points. Return on assets before bonus distribution will likely reduce to about 1.2%-1.3%.

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Earnings' prospects will very much depend on the further development of interest rates. Under our base-case scenario for 2014-2015 we expect these to continue to recover slightly, therefore easing pressure on the average coupons in the back book. However, we do not believe an increase in line with our base-case scenario would be sufficient to result in a strong recovery of earnings for German life insurers. The sector on average is operating with increased asset durations, so that it will take longer for interest rate trends to show in their portfolios. On the contrary, rising market yields could easily wipe out existing asset value reserves on fixed-income investments, thus rendering it difficult for companies to stabilize their investment results through realized gains.

Property-Casualty: Sound Medium-Term Prospects, Despite Short-Term Pressure From Natural Catastrophes
Germany's property-casualty (P&C) insurers in our view are less vulnerable to low yields than life and health insurers, as long as they can continue improving their underwriting profitability. Companies have in general returned to more adequate risk pricing, reflecting both adverse claims experience, particularly in motor and homeowners' insurance, and by adjusting rates for lower investment returns. The increase in average premiums per contract in 2011 and 2012 demonstrated this and we expect this to continue over 2013-2015 (see chart 7). In 2013, however, the sector was hit by various natural catastrophe (nat cat) events that will likely push up the sector's average combined ratio toward 100% (a ratio of more than 100% signifies an underwriting loss). The underlying trend in underwriting profitability will nonetheless be positive, in our view, thanks to further rate increases, which we expect will continue in 2014 and 2015. This should support a recovery of earnings in 2014, with combined ratios at normalized nat cat experience of 96% to 97%, according to our forecast.

Companies are set to implement further rate increases

Various factors are forcing P&C insurers to raise their premiums. They have experienced a swift drop in operating performance between 2008 and 2011, owing to deteriorating underwriting and investment returns. In terms of underwriting profitability, decreasing average premiums per contract combined with higher claims indicated weakening pricing in the sector, particularly in loss-making lines such as motor and homeowners' insurance. Motor alone accounts for almost 40% of the sector's total gross premiums written, making it crucial for the overall sector's growth and underwriting profitability. Cost efficiency and a strong claims' management are therefore crucial to strengthening profitability in this segment. Since 2011, P&C insurers have reacted by implementing rate increases, as increasing averages for premium per contracts in 2011 and 2012 demonstrate. Motor and homeowners' insurance were among the lines with the most pronounced increases. Still, both lines continue to produce underwriting losses. For the sector as a whole, the net combined ratio strengthened to 97% in 2012 from 98% in 2010, according to GDV figures. We also think that companies on average continue to adhere to conservative reserving practices when comparing with foreign property-casualty markets.

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Chart 7

In 2013, we believe the industry has continued to follow through with additional rate increases, particularly in motor. Nonetheless, the sector may not produce positive underwriting results this year because of severe natural catastrophe losses (see table 2).
Table 2

Severe Natural Catastrophe Events In Germany In 2013

Date Early June Event Severe floods following an already rainy spring overall. May saw severe rain falls throughout Central and Eastern Europe that resulted in several rivers overflowing. Severe hailstorms Storm Affected regions Baden-Wrttemberg, Bayern, Brandenburg, Niedersachsen, Sachsen, Sachsen-Anhalt, Schleswig-Holstein und Thringen Baden-Wrttemberg, Niedersachsen, Sachsen-Anhalt, Nordrhein-Westfalen Northern Germany Industry insured loss estimate German insurance association (GDV) estimate: 1.8 bil. GDV estimate: 2.7 bil. Aon Benfield estimate: 300 mil.

Late July, early August Late October

The flood in June, hailstorms in July and August were among the highest insured losses ever experienced for these types of natural catastrophes in Germany. Together, their impact could push up the P&C sector's gross combined ratio in 2013 by about four to five percentage points. The business lines likely to be hit hardest are those that are already the

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least profitable, namely motor (especially comprehensive cover), property, and homeowners' insurance. We also expect significant variations in individual companies' losses, reflecting their regional focus and portfolio characteristics. We believe claims from these events will exceed the annual budgets for natural catastrophes for most German P&C insurers. With the gross combined ratio moving toward 100% or even higher in the sector, underwriting profitability in 2013 could now be out of reach for many insurers. Existing reinsurance coverage will smooth net performance, while reinsurers have indicated they will seek higher rates for reinsurance protection from 2014. In light of the series of nat cat events and capital budgeting in the wake of Solvency II requirements, we believe a review of reinsurance programs will feature highly on primary insurers' management agendas.

Health Insurers: Competitive Weakness And Political Uncertainty Pose Risks

Low interest rates are weighing on the competitive position of Germany's private health insurance sector. While the private health insurers have the right to adjust premiums to offset medical claims inflation, an increase in premiums reduces the perceived attractiveness of comprehensive health care offerings. Health insurers also face political risk surrounding potential future political reforms to the dual health insurance system. A pronounced political change, although not expected in our base-case scenario, could prohibit private health insurers from seeking new comprehensive business, which would not only erode their competitive position but also their earnings. An increase in bond yields would support the sector by likely reducing the need for premium adjustments.

Price increases put pressure on new business growth

The sector reported a decline in comprehensively insured people for the first time in 2012, and the slide will likely continue in 2013, owing to various competitive pressures. Above all, the sector is being forced to raise premiums for a variety of reasons, including: Inflation of medical costs, leading to increasing claims costs. Because of the industry's premium adjustments clauses, these are resulting in steadily increasing rates. Decreasing investment returns. This gives insurers less capacity to offset claims inflation and the build-up old-age provisions designated to stabilize premiums. An inability of a reasonable number of health insurers to meet the technical interest rate ("Aktuarieller Unternehmenszins"), forcing them to make exceptional rate increases. The introduction of unisex tariffs that came into force on Jan.1, 2013. A repricing of previously inadequately priced comprehensive health insurance cover for certain customer segments. These factors, alongside concerns over the future long-term stability of these rates because of an aging population are making comprehensive private health insurance less attractive to customers. New business sales have also declined since April 2012 partly because, after some excesses in distributors' remuneration, the government introduced maximum commission rates and prescribed a minimum period of five years for reversal liabilities. These factors have reduced sales activity by distribution channels, in particular by brokers. Meanwhile, the private health insurers' main competitors, statutory health insurers, are benefiting from the economic upswing, given that their premium income is linked to the available income of their insured. Lower unemployment rates and higher household incomes therefore result in growing revenues, which reduces pressure on further raising

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contribution rates. The desire of various political parties to abolish the dual health care system, is also amplifying uncertainties for health insurers. Even if this discourse does not result in such drastic change following the outcome of the 2013 federal elections, some revisions to the status quo can be reasonably expected, which adds to the uncertainty for potential and existing policyholders with regard to the sustainability of the comprehensive health insurance product.

Supplementary products could boost growth

Private health insurers continue to report satisfactory growth rates in insured persons for their supplementary health insurance products, which customers buy to supplement statutory health insurance cover. Increasingly, this includes long-term care products, such as old-age nursing care, that complement the existing statutory care insurance. The introduction of the so-called "Pflege-Bahr", through which the state subsidizes monthly premium payments for nursing care ,will likely support growth over the coming years, although some political controversy surrounds these products. However, premiums per contract are much lower than for comprehensive cover. Some companies are also increasingly eying group life health insurance products, which are sold to employees through their employers.

Capital and earnings trends

Health insurers' investment returns are also affected by low interest rates. This is not fully showing in reported investment returns so far, given companies' realized gains on low interest rate-induced asset value reserves. In general, health insurers are less vulnerable to low interest rates than life insurers given that a larger part of their gross surplus is based on underwriting profits. Over the past five years, the investment result accounted for 34% of total gross surplus, on average. Also premium adjustments are an important feature of the private health insurance sector, accounting for a substantial part of the growth in gross premiums written, and supporting stable earnings. The sector's underwriting profit ratio (underwriting profits as a percentage of gross premiums earned) has trended upward since 2010, reaching about 13% in 2012 from only 8% in 2009, which gives some flexibility to manage claims inflation prospectively. This has helped the sector's capitalization, as strengthened bonus reserves since 2010 demonstrate. The bonus reserve ratio (bonus reserves as a percentage of gross earned premiums) increased to about 30% in 2012 of 26% in 2010. For 2013, we expect a moderate improvement in the sector's underwriting profit ratio as well as in the bonus reserve ratio.

Capitalization Will Hover Broadly In Line With Current Ratings

After improving in recent years, we expect rated German insurers' capital adequacy will stabilize at best in the period 2013-2015 (see chart 8). On average, their capital position exceeded the 'A' risk capital requirements under our criteria by 11% at year-end 2012, compared with 1% at year-end 2011. This is predominantly because growth in total capital outgrew the moderate growth in risk-based capital requirements, driven upward merely by higher credit risk exposures and moderate volume growth. Non-life insurers generally continue to be more strongly capitalized than life insurers, and the capitalization of diversified insurance groups usually benefits from more strongly capitalized non-life operations.

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Chart 8

Over the period 2013-2015, we expect in our base case that the capital adequacy of rated German insurers will stagnate. For 2013 specifically, we expect that bonus reserves and net incomes of rated life and health insurers will remain stable at best. Life embedded values, however, one component of our broader economic view on capital, will likely recover from previous years if interest rates and volatilities remain at current levels until year-end. For P&C insurers, this year's large claims from natural catastrophe events will likely adversely affect bottom-line profitability and equalization reserves, which could trigger some reserve releases. We expect that risk-based capital requirements will increase marginally in view of some exposure growth.

Solvency II Implementation By 2016 Will Burden Insurers

Discussions by the EU trilogue (comprising the European Commission, European Parliament, and Council of the EU) earlier this month have finally paved the way for Solvency II regulations for insurers. We believe the schedule to implement them by 2016 will be burdensome for insurers. We would view negatively those insurers that use the transitional measures to delay necessary adaptations to insurers' product portfolios, economic pricing, and capital management. The Omnibus II Directive, agreed by the trilogue on Nov. 13, 2013, sets out key milestones of the Solvency II framework, implementation timeframe, and transitional measures. In particular, the way in which the rules

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quantify capital requirements for long-term guarantees in traditional life insurance portfolios are highly significant for German life insurers with large shares of traditional guarantee business. We recognize that the future long-term guarantee approaches under the Solvency II framework may throw up significant challenges for some life insurers' existing business models (For further details see Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains, published July 31, 2013. We expect that financially strong German life insurers will continue to be able to offer traditional guarantee products in the future, while others may not. We believe that life insurers will have to make considerable changes to their product design, pricing, investment, and capital management. We continue to deem it appropriate that some of the recommended measures will provide insurers with more time to take necessary action to deal with the complexities of managing long-term business. However, we will view negatively those insurers who use the extra time to delay taking actions that are economically justified. German life insurers in particular will benefit from the 16-year transition to the new rules, during which they will be allowed to calculate capital requirements for traditional inforce portfolios with old Solvency I requirements. This should give them time to steer their long-duration inforce books with up to 4.0% policyholder guarantees toward less capital-intensive products and build capital over time. Nevertheless, we believe life insurers may consider that fully meeting Solvency II requirements significantly sooner could give them a competitive edge in the eyes of various stakeholders. Those insurers that had hoped to see a further delay of Solvency II may find themselves at a disadvantage because they will clearly now have to invest resources and catch up by 2016. The concrete specification of implementing measures through the EU Commission and technical standards through EIOPA during 2014 will be essential to ensure the 2016 implementation timeline remains within reach. We believe that the introduction of MA Risk in 2009, which defined minimum requirements for risk management, has provided a good footing on pillar II for German insurers. Still, the Solvency II framework will take regulatory requirements to a new level, and companies that did not already start preparing several years ago may be challenged to meet reporting and documentation requirements.

Continued Low Interest Rates Portend Challenges Ahead

Low yields will likely continue to weigh on German insurers' performance over the coming year, although to varying degrees. Non-life insurers merely need to strengthen their underwriting performance to offset lower investment returns, which in our view will require adherence to a prudent pricing approach. Life insurers, however, will have to maintain a healthy spread between investment returns and guaranteed rates to protect their earnings, capitalization, and their ability to sustainably meet policyholder commitments. For some life insurers, this might well mean that they have to implement profound changes to their business model, particularly in terms of the products they offer. The fall in customer confidence and increasing competitive pressures in less interest-rate-sensitive product lines will not make their task any easier. Insurers' financial strength over the coming months will also very much depend on financial market developments. A renewed intensification of the eurozone sovereign crisis could affect both profit-and-loss

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statements and balance sheets in the short term. A sustained but not too rapid increase in interest rates, on the other hand, could prove supportive of the industry's financial strength, especially if companies quickly adapt their business models to the low yield and new regulatory realities.

Related Criteria And Research

All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated. Insurers: Rating Methodology, May 7, 2013 Europe Is Moving From Subzero To Subpar Growth, Sept. 18, 2013 Germany's Life Insurance Sector Carries An Intermediate Industry And Country Risk Assessment, Nov. 8, 2013 Germany's Health Insurance Sector Carries An Intermediate Industry And Country Risk Assessment, Nov. 8, 2013 Germany's Property & Casualty Insurance Sector Carries A Low Industry And Country Risk Assessment, Nov. 8, 2013 The Low-Interest-Rate Fog Over Global Life Insurers May Be Lifting, July 25, 2013 A Cluster Of Natural Catastrophe Claims Could Put Underwriting Profitability In German Property-Casualty Insurance On Pause, Aug. 13, 2013 Planned Additional Reserving For German Life Insurers Implies Short-Term Pressures But May Bring Long-Term Gains, March 17, 2011 Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance Capital Model, June 7, 2010 Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains, July 31, 2013

Additional Contact: Insurance Ratings Europe; InsuranceInteractive_Europe@standardandpoors.com

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