Wednesday, 30 November 2011
Extra sovereign risk charges for Solvency II unlikely in near term-Fitch
Solvency II is unlikely to include revised capital risk charges for European Economic Area (EEA) sovereign bonds in the near term because the European Commission will want to avoid any market disruption that this could cause, according to credit rating agency Fitch Ratings.
The agency says that the Commission is likely be ‘sensitive to the fact’ that some financial market participants and commentators are questioning whether the euro will survive in its current form.
If it were to add risk weights to some, but not all, eurozone member countries this could be seen as recognition of these concerns and possibly push a significant number of insurers that are currently able to meet the Solvency II capital requirements into the red.
Fitch points out that the eurozone sovereign debt crisis has persuaded a number of market participants to question Solvency II's uniform assessment of own-currency sovereign debt from the EEA as risk-free with a zero capital risk charge.
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But the agency adds that the zero risk charge in the Solvency II standard formula does not necessarily mean the risk is not taken into account by insurers.
“Many, especially larger, insurance groups use internal models to calculate capital which factor in risk capital for sovereign defaults. Capital increases, which can be added by regulators under Pillar II to reflect risk not captured in the standard formula, may also be imposed,” stated Fitch.
“Crucially, moving to a mark-to-market balance sheet means that insurers are already largely factoring current market expectations for default and some of the illiquidity concerns. Given that an Italian 10-year bond is trading at 85% of face value and an Irish 10-year bond is trading at 78%, this already goes some way to factoring in the risks insurers are taking of default on the bonds. These adjustments flow directly into the solvency position under Solvency II,” continued the credit rating agency.
Fitch said that calls for a rethink on the treatment of eurozone sovereign debt are ‘understandable’ and it said that it thinks charges could be added if eurozone government bond markets stabilise. But, the agency believes that it is unlikely that such changes will be incorporated into Solvency II in the near term.
“With Solvency II due to take effect from 1 January, 2014, the timeframe for adding charges before this date is tight. But the Commission has been willing to make major changes to the charge structure and discount rate on corporate bonds without widespread testing, so it should not be assumed that introducing charges for sovereign bonds would automatically require another Quantitative Impact Study,” stated Fitch.
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