The COVID-19 pandemic hit the German economy hard, leading to a decline in GDP of about 5% in 2020. But German insurers have withstood this challenging year well: ratings remained largely stable, with the average rating in the upper 'A' category. As of March 15, 2021, 86% of the 60 German insurers we rate had a stable outlook, while negative and positive outlooks balanced each other out at 7% each (see chart 1). Most negative outlooks reflect pressure on industrial insurance performance and negative outlooks on insurers' parents, in particular banks. Ratings on German insurers continue to benefit from the insurance groups' diversity: most groups write multiple lines of business, including life, health, and property/casualty (P/C).

Overall, German insurers' operating performance was volatile throughout 2020, but ended much better than we had previously anticipated at the mid-year point. In particular, the capital market recovery, lower claims frequency in motor and household insurance, and a benign natural catastrophe year helped the sector to post 2020 earnings only a little below 2019. While underwriting results have been barely harmed by the pandemic, except for business interruption and event cancellation, the main impact from COVID-19 resides on insurers' investments. Investment volatility and low-for-longer investment yields are hurting all lines of business, but we expect life insurers will be hardest hit, owing to still high back-book guarantees of about 2.5% in 2020 and a greater dependence on investment income than P/C and health segments.

Chart 1a

Chart 1b

Capital Is Still A Strength

German insurers continue to benefit from solid capital adequacy (see chart 2). Rated Germany-based primary insurance groups entered the COVID-19 pandemic with a strong capital buffer of about €21 billion as of year-end 2019 on the 'A' level, according to our capital model. This was slightly up compared to 2018 (about €20 billion). The sector experienced significant capital market volatility in 2020, with credit spreads widening, equity market downturns, and selectively lower income, for example from commercial property. However, the strong capital market recovery in the second half of the year and overall sound underwriting results helped to maintain capital at a 11%-13% redundancy on the 'A' level in 2020. We believe German insurers' capital adequacy will remain a rating strength in 2021-2022 based on our assumption of continued strong underwriting performance in P/C, while asset-liability mismatch risks appear likely to remain stable.

Chart 2

Investment Allocation Is Changing

Insurers' asset risk appetite has evolved in response to low-for-longer interest rates. Companies have shifted further toward illiquid assets, such as property or participations (see chart 3). However, the largest block of investments remains fixed-income securities. Here, we have seen a shift from sovereign bonds into corporate bonds in recent years, while the average rating is still high in the 'AA' to 'A' range (see chart 4). We have also observed a material shift out of German Bunds into other European Economic Area sovereign debt, which now outweighs domestic sovereign debt exposure.

Chart 3

We will monitor in particular the credit quality of insurers' corporate bond portfolios, particularly in pandemic-affected industries such as energy, aviation, transportation, leisure, and capital goods (see "COVID-19- And Oil Price-Related Public Rating Actions On Corporations, Sovereigns, International Public Finance, And Project Finance To Date," published Feb. 23, 2021). Areas such as commercial real estate, that were already hit in 2020 by lockdown measures might face a new normal post the pandemic.

We expect insurers to make further adjustments to their asset exposures in view of the low-for-longer interest rate environment, turning toward more illiquid or risky assets such as infrastructure, property, listed equity, and private equity. However, we assume asset risk appetite will remain balanced and will not increase materially. Consequently, we believe running investment performance for German insurers on average will decrease by about 20 basis points per year in 2021-2022. Declines in P/C are likely to be more pronounced due to shorter duration of their asset portfolios compared to life and health.

Chart 4

Pandemic Adds Pain For Life Insurers' Investment Results

Losses from increased mortality from the COVID-19 pandemic have been very limited for the German life insurance sector. This is because mortality rates have been observed mostly in older and uninsured groups. Ongoing low interest rates, however, are weighing on life insurers' investment results, and market movements in 2020 related to the pandemic added pressure on the sector. Yield-curve flattening indicates a low-for-even-longer yield environment.

Headwinds from a low-yield environment are nothing new to the sector. In light of high Solvency 2 requirements for traditional life products, many life insurers have launched life products featuring alternative guarantee concepts and additionally built momentum in risk-type products--term life and disability products. Yet, while this shift is visible in the sector's new business split, we believe it will take time before the move to capital-light products will have a large impact on the average guarantee rate in the pension back books.

Chart 5

German life insurance business volumes and sales held up relatively well against the significant recession in 2020 and operational challenges stemming from lockdown measures. After a few years of declines in gross written premiums (GWP) stemming from the loss of attractive returns for traditional life products, premiums in 2019 expanded by an extraordinary 11.5%, driven mainly by one product line--premium depots. Even through the challenging year 2020, GWP decreased only slightly by 0.4%. We believe this is due to changes in insurers' product portfolios and customer demands, combined with stable, low surrender rates. We expect further GWP growth rates of about 2% over the period 2021-2023.

German life insurers remain sensitive to low yields and are more dependent on investment results than health or P/C sectors. Low yields are eroding the spread between investment income and guaranteed rates on life insurance policies. In particular, many insurers are financing the allocation for additional reserving requirements ("Zinszusatzreserve", ZZR, which requires life insurers to put aside extra reserves to ensure their ability to meet their long-term guarantee commitments to policyholders) by realizing fixed-income valuation reserves. This bolsters their reported total investment returns. But by contrast, it decreases the net investment return measuring the current yield. The average guaranteed rate is still very high, having declined only very gradually by 10-20 basis points (bps) annually. For 2020, we estimate it was about 2.5%, calculated on the basis of total invested assets and excluding the ZZR impact (including ZZR the guarantee stood at 1.6% in 2020).

Although companies have already largely reduced their annual bonuses, they are still suffering from 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 policyholder capital available to absorb losses. The weighted average return on assets (pre-tax gross surplus before bonus distribution divided by average total assets) for the 50 largest life insurers reduced to 1.1% in 2016 from 1.8% in 2013, but remained stable until 2019. We also estimate it to have remained stable in 2020 and beyond, demonstrating the tightened potential to build policyholder capital buffers.

Chart 6

Unsurprisingly, earnings prospects will depend heavily on the future development of interest rates. Under our base-case scenario, pressure will remain on the average coupons in the back book. The sector has increased asset duration on average, and we do not rule out that some insurers will lengthen it further.

Life insurers are adopting various defensive measures to maintain their profitability and financial strength in a low yield environment. We think that some of these measures will take time to bear fruit. The most effective short-term lever to protect policyholder capital buffers and financial resources besides the ZZR is to lower policyholder bonuses. Other strategies to offset low yields, such as strengthening risk results or changing the inforce book composition through new business shifts, will take years to achieve any meaningful impact. Consequently, we anticipate that life insurers will increase their efforts to improve their underwriting performance and cost efficiency.

Chart 7

Based on our projections of gross surplus trends for the life insurers we rate, we expect that the German life insurers will be able to meet their policyholder guarantees at the very least over our projection period until 2025 under our base-case scenario. However, the market movements resulting from the COVID-19 pandemic (widening credit spreads) put further strain on industry participants' cash flows.

Property/Casualty: On A Successful Path

Despite the ongoing pandemic, the market environment for German P/C insurers remains stable, based on the improved underwriting results in the recent years. Low investment yields have prompted the industry to focus on sustainably restoring and improving underwriting results, as well as subsequently implementing rate increases, in particular in cyclical business lines, such as building, legal expense, and motor insurance. We believe the German P/C insurance industry will be able to achieve a return on equity of between 9%-12% for 2020-2022, mainly driven by continued pricing discipline but also pressure from further declining investment returns. We expect the increasing importance of underwriting results compared to investment income to continue (see chart 8).

Chart 8

For 2020, we expect sound profitability in the sector, with a very strong gross combined ratio for the market of around 90%, mainly driven by the lower economic activity and strong results in motor due to low traffic volume. The lower claims caused by the pandemic-driven limited economic activity in 2020 are more than offsetting the COVID-19-related claims from business interruption, event cancellation, and credit insurance. Further, the P/C insurance market has experienced a benign claim environment for natural catastrophe (nat cat) losses, with no material hail or storm claim events in 2020. According to the German insurance association, nat cat claims will be around €2.5 billion below the average of €2.8 billion for 2015-2019.

According to the German Insurance Association premium growth was about 2.1% for 2020 compared to 3.5% in 2019. The slightly lower increase in 2020 is mainly driven by premium reductions in motor insurance, and some COVID-19-related distribution challenges, particularly in the months of March and April.

Chart 9

The gross combined ratio in all major lines of business has remained below 100% since 2015, as a result of a hardening cycle that began in 2011, and we do not expect the hard market to soften materially as long as interest rates remain low.

Prospectively, we assume the German P/C insurance market will maintain similar profitability levels in 2021-2022, with gross combined ratios of between 93%-96%. This assumes a normalized nat cat burden closer to the five-year-average of about €2.8 billion and an uptick in traffic volume, leading to higher motor insurance claims.

We expect premium growth of between 1%-3% over 2021-2022. On the one hand, we envisage a slight increase in competition in motor due to very strong results in 2020. On the other, we forecast GDP growth of 3.7% in 2021, supporting sustainable growth in the German P/C insurance market.

Health Insurers: Stable Claims Costs Despite The Pandemic

Germany's private health insurance industry coped well through the pandemic in 2020. We assume technical results improved last year. We estimate that the loss ratio will be 1-2 percentage points lower in 2020 than in 2019 at around 78%-80%, whereas the cost ratio remains quite stable at around 8%-9% (see chart 10). This, together with an increase in premium income, will likely result in an improvement in the underwriting profitability ratio by 1-2 percentage points for 2020. We expect return on equity (RoE) to remain stable in 2020, confirming the sector's robustness, with a five-year average 2015-2019 of 11.6%.

Chart 10

Despite the pandemic, health insurers reported only slightly higher claims in 2020 (+0.2%) in absolute terms, because some medical treatments and operations were postponed to provide extra capacity for COVID-19 patients. At the same time, the private health insurance sector together with public health insurers covered pandemic-related costs, such as testing, protective equipment for medical staff, and additional intensive-care beds. We believe this, in combination with the catch-up effect from postponed medical treatments in 2021, could lead to higher costs and could impact the loss ratio in 2021, bringing it back to pre-2020 levels.

Prospectively, we assume the German health insurance market will continue to post strong underwriting results, with RoE between 9% and 11% and an underwriting profitability ratio between 10%-12% in 2021-2022. This takes into account constraints in earnings prospects from demographic challenges, medical-cost inflation amid ongoing low interest rates, and only moderate premium growth. We believe these long-term challenges will be absorbed predominantly by the premium adjustment mechanism. Still, the ongoing low interest rate environment in particular will weigh on investment results.

Despite the challenging market environment, premiums in the sector expanded by 3.8% in 2020. In particular, the demand for occupational health insurance and supplementary coverage has increased. We expect both products to further drive volume growth, but not offset the decline in full comprehensive health insurance business. For the ninth year running, full comprehensive health coverage contracted, by 0.1% in terms of people insured, whereas the sector as a whole grew by 1.8% in 2020. We believe the sector will continue to face challenges to attract new business for full comprehensive health coverage, considering people might not meet the income threshold required for comprehensive insurance due to pandemic-related short-time work or unemployment. Hence, we forecast only small increases in GWP of 1%-2% over 2021-2022 (see chart 11), attributable mainly to premium adjustments and growth in supplementary coverage rather than new business for full comprehensive health cover. For 2021, we expect premium adjustments to be around 8% across the market. Moreover, the sector's growth prospects still depend on decisions by policymakers over the continuation of full comprehensive cover. This may be discussed in the context of the 2021 federal election.

Chart 11

Mixed Conditions Ahead

Overall, the pandemic heightened some of the challenges the German insurance sector was facing prior to COVID-19. In particular, the low-for-even-longer interest rate environment will keep life insurers on their toes in managing their back books. At the same time, we believe P/C insurance will need to continue its focus on underwriting profitability, with more limited scope for price wars than in prior price cycles given lower investment returns. For health insurers, balancing the very low interest rate environment against medical inflation via its premium adjustment features will be key. Nevertheless, ratings on German insurance companies have remained robust throughout the COVID-19 pandemic. Through 2021 and 2022, we expect their good diversification, sound capital adequacy, and focus on underwriting profitability will counter these accelerated challenges and maintain ratings stability.

Related Research

• COVID-19- And Oil Price-Related Public Rating Actions On Corporations, Sovereigns, International Public Finance, And Project Finance To Date, Feb. 23, 2021
• European Corporate Credit Outlook, Feb. 3, 2021
• Insurance Industry And Country Risk Assessment: Germany Property/Casualty, May 20, 2020
• Insurance Industry And Country Risk Assessment: Germany Health, May 20, 2020
• Insurance Industry And Country Risk Assessment: Germany Life, May 20, 2020