Participating life insurance contracts under Solvency II: inheritance effects and allowance for a Going Concern Reserve

Some details of the Solvency II framework are still under discussion. A crucial aspect in the debate is the appropriate reflection of surplus participation mechanisms that apply to traditional participating life insurance contracts. In particular, the inheritance of profits between existing business and new business resulting from the surplus participation process has to be incorporated in the Solvency II valuation framework which requires a run off valuation of the existing portfolio under going concern assumptions. This paper analyzes the inheritance effects caused by the pre-financing of acquisition cost of new business via cost surplus of existing business which is inherent in traditional German life insurance. We show that in the context of Solvency II an allowance for the inherited funds-denoted as Going Concern Reserve (GCR)-is justified and in line with the Solvency II valuation principles. Based on a stochastic balance sheet and cash flow projection model, we present a methodology to quantify the GCR and provide a profound analysis of the GCR and its components. Our results show that the GCR has significant impact on the overall solvency situation of life insurance companies offering participating contracts.