Credit risk weighs more on planet S-II

A rise in government bond yields in May failed to lift insurance stocks. The parallel increase in credit spreads offers a possible reason why.

We have written in the past about how far Solvency II numbers might influence stock prices, with the expectation that the markets will watch firms’ capital positions more closely as implementation approaches.

Recent events seem to suggest that it is not happening yet. Government bonds have been sold off across Europe, pushing yields up, which should be good for insurers from a capital perspective. But the STOXX Europe 600 Insurance index fell by 8% in May. Why?

Analysts from JP Morgan propose a possible explanation. In a recent note Ashik Musaddi, London-based European insurance analyst at the firm, says share price falls could be attributed partly to rising credit spreads.

Rising government bond yields help the insurance sector by reducing the reinvestment risk for duration-mismatched portfolios and improving solvency positions. But higher credit spreads mean lower asset values without any equivalent reduction in liabilities (except for firms using the matching adjustment), he argues. Spreads on European credit default swaps (CDSs) have widened by about 15 basis points (20%) since early March.

Musaddi’s note charts 10-year European CDS spreads versus the Stoxx insurance index, showing insurance sector shares moving inversely to CDS spreads during the period from January 2013 until now.

A mood for change

If Musaddi is correct – and investors are closely watching insurers’ economic capital, and credit risk in particular – an interesting question is how they might react to the changing treatment of credit risk for sovereign bonds.

As we investigate in our cover story (Sovereign battle), insurers are shielded under the Solvency II standard formula from sovereign credit risk on the asset side of the balance sheet because government bonds are treated as
risk-free.

That position, though, seems likely to change at some point. Led by an opinion from Eiopa in April, some regulators are pressing internal model firms to model sovereign risk more thoroughly – including the risk of default and rating migration.

Their view is not universally accepted, however, with a second group of regulators arguing that sovereign risk should be excluded from firms’ Pillar 1 calculations. The debate is seen as the precursor to changes to the standard formula – perhaps in 2018, when it is first reviewed.

Should the treatment be revised at that point, investors will need to turn attention also to the influence of sovereign credit risk on insurance company balance sheets.