Germany's life insurers: the next crisis?

Tucked away in the International Monetary Fund's latest analysis of global financial stability are a couple of pages of disturbing warnings - not about the crisis in Greece, nor China's waning growth. This time, the bogeyman is Europe's, and particularly Germany's, normally low-profile but now high-risk life insurance sector.

According to the IMF, the failure of one life insurer "could trigger an industry-wide loss of confidence", that in turn "could engulf the financial system". Is it being alarmist? Or could this be the root of another financial crisis?

Lebensversicherungsgesellschaften - or life insurers - have been the bedrock of Germany's long-term savings culture for two centuries, offering attractive guaranteed returns to millions.

It is a big industry, with more than €90bn of annual premium income and close to €900bn of assets under management. But it looks fragile. It is fragmented, with more than 90 companies competing. And many of them are mutuals. That restricts their access to capital and leaves them more vulnerable to tough times.

And make no mistake: these are tough times.

Some of the challenges are common elsewhere - most obviously, the persistently low interest rates that constrain investment returns. But there are idiosyncratic pressures in Germany. A predominance of guaranteed long-term policies is doubly difficult for life insurers to sustain.

First, guaranteed rates far outstrip today's meagre investment returns. Although new policy guarantees are capped by law at 1.25 per cent, the long tail of policies - which typically extend for 30 years - means average guarantees are still running at 3.2 per cent. Compare that with the 0.14 per cent yield on 10-year Bunds and the tension is becomes obvious. Second, there is a big mismatch between liabilities (averaging 20 years' worth) and assets (of more like nine).

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At the same time, insurers' ability to grow their way out of trouble is constrained. New policy holders find the low level of guaranteed returns unappealing. And the German state has been unhelpful, too. Irking the fiscally troubled nations of Europe, the relatively flush Germany treasury last year tweaked rules to cut the retirement age from 65 to 63 and boost state benefits for segments of the population.

Regulators have sought to ease the pressure by instituting a Zinszusatzreserve, or ZZR: a requirement to set aside funds to meet long-term liabilities. Had this been introduced in the good times, it would have been sensible. Today, though, it is counterproductive. Because many insurers have had to cash in investment gains to fund the ZZR, it acts as a drag on longer-term performance.

Amid this cocktail of problems, many insurers will have to eat into capital. A Bundesbank stress test found that a third of the sector would be short of capital in the kind of extreme interest rate scenario that is already emerging.

<>Europe's incoming Solvency II rules on capital will complicate the situation further. Although the rule book may ease the capital squeeze for some larger insurers, and postpone the recognition of problems for others, it will be a headache for many. Without the cash flow to fund guarantees, smaller, weaker operators may fold. That, in turn, could hurt the whole sector reputationally, and also financially - through Germany's industry-funded safety net.

Shareholders and bondholders face unpredictable consequences. While banks have had to boost equity levels dramatically, insurer capital can still be funded in large part with debt. According to Moody's, no insurer has yet issued loss-absorbing "Tier 1" instruments that would behave like banks' contingent convertibles, or cocos.

As the IMF points out, this is a sector that has a "high and rising interconnectedness" with the wider financial system, largely through investment and liquidity links with banks. Germany is an extreme example. But it is not unique. From Norway and the Netherlands to Japan and Taiwan, similar issues are building. This might not be a 2008-style crisis in the making. But it could still hurt.

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