Posted on Nov 11, 2011 by Sergio Ulloa
A new briefing released this week by global ratings agency Fitch Ratings has warned that Italy's insurance companies cannot expect to pass their losses onto their policyholders in the unlikely event that the Italian government defaults on its upcoming debt obligations.
The Euro-zone's sovereign debt crisis has continued unabated this week with Italy being the next market apparently on the verge of financial meltdown, an event which could have dire ramifications for both Europe and the rest of the global economy. On Wednesday, Italian bond yields hit 7.4 percent, a point widely considered to be unsustainable, and work is underway to quickly form a new coalition government and pull Italy's economy back from the brink of default. Multinational investors and financial institutions have however begun casting more serious doubts over Italy's ability to weather another market downturn, and now Italian authorities are turning to the insurance industry for assistance. The country's total debts however, now standing at over US$2 trillion, could mean that they are in fact beyond rescue while tied to the Euro, even by the insurance industry.
The European Union (EU) has been working with the continent's leading banks and insurance companies to devise a new program to solve the pervasive sovereign debt crisis which has crippled the region's economic output over the past few years. After much deliberation, the EU has planned out a new debt insurance model for the region, which is designed to both protect investors and offset the risks of loaning money to heavily-indebted Euro-zone countries going forward. While the plan to get all EU creditors to agree new terms may work in the long run, Italy may not be a beneficiary, as Germany and France could petition the EU to remove the country from the union for the sake of the coalition's overall financial stability.
Italy is thus looking for help from the country's insurance industry, hoping to obtain some protection for government bonds and to help mitigate the impact of a potential economic catastrophe. Insurance could protect the value of these bonds and work to significantly reduce the risk of borrowing to international lenders. However, no amount of insurer activity could offset Italy's massive long term debts, so the government must hope to remain an EU member by the time their new expansive new debt insurance plan comes into force, likely next year.
For the Italian insurance companies meanwhile, ongoing domestic economic uncertainty put their operations and policyholders at significant risk. According to Fitch, there is an intrinsic link between Italian insurer performance and the nation's overall sovereign credit rating. Italy's insurance companies generally hold large volumes of Italian government bonds in addition to securities issued through Italy's financial and other institutions. Furthermore, most Italian insurers have principally been domestic players with little presence in lucrative overseas insurance markets and thus are overtly linked to an economy in which impending government austerity measures are likely to further dampen private consumption and investment in protection products in the coming years.
It was based on these indicators that Fitch decided to first downgrade Italy's outlooks for their life and non-life insurance sectors from stable to negative on October 12. The ratings agency has also assigned a 'A+'/Negative rating on the country's sovereign debt, which means government bonds remain at a low risk of default. However, if the unlikely event of a sovereign default were to occur, Fitch believes that the ability of Italian insures to pass further losses on to policyholders to absorb would be significantly weakened, as the return on customer portfolios may be well below the minimum guaranteed to these policyholders. Insurers would thus be liable for these additional losses. Fitch further hypothesized that if the sovereign default happens, the amount lost on Italian debt holdings could damage Italian insurer capital adequacy to a greater extent that already realized. This has become one of the principal reasons Fitch believes the Italian insurance industry deserves the negative outlook.
The current situation has been made worse for insurers in Italy than compared to those in other European economies, such as Germany, because there has never been an effective attempt to defer profit-sharing and short-term thinking in the country's insurance market. What this means is that, in the event of a prolonged market downturn or default, most Italian insurance companies have no capital buffer from previous unrealised profits on the balance sheet to protect themselves or their clients. "Historically, Italian companies built a cushion of unrealized gains largely on domestic sovereign debt that could be used to cover guarantees when investment income was insufficient to meet the guaranteed return. This cushion has shrunk in recent months as credit spreads on Italian debt have widened, driving down the value of existing bonds and giving insurers less protection against further market volatility," Fitch said in their research.
The insurance industry across Europe faces a multitude of problems. The continent's sovereign debt crisis has occurred while a soft market and stubbornly low interest rates across multiple business lines persist, which keep pricing low and puts downward pressure on insurer profitability. Attempts to increase premium levels are met with resistance in a weak economic climate, as consumers are unwilling to pay higher rates, if in fact they can afford insurance at all. Added to this has been the upcoming Solvency II regulations, which require many firms to taper their business ambitions and set aside greater capital reserves. Overall, stagnant economic growth in Europe's principal markets have both increased the possibility of a double-dip recession and exacerbated the sovereign debt crisis in a number of peripheral Euro-zone countries, namely Portugal, Italy, Ireland and Greece.
Fitch Ratings is a global rating agency and provides ratings and analytical services for thousands of banks, financial institutions, insurance companies, corporations, and national governments. Fitch was founded in 1913 and now features dual headquarters in New York and London with over 50 offices worldwide,