Crumbling relations

The so-called ‘Piigs’ countries – Portugal, Ireland, Italy, Greece and Spain – have been an ongoing source of worry for the financial markets in 2010. While the prospect of a Eurozone country being allowed to default appears low, insurers are under greater pressure than ever to tighten up their sovereign bond portfolios. Sarfraz Thind reports

Sovereign risk has dominated the financial markets this year. The fallout from Greece’s fiscal woes has shaken confidence in European sovereign bonds, once considered to be the safest of investments. The five countries affected most – Portugal, Ireland, Italy, Greece and Spain, which together have been given the somewhat pejorative acronym Piigs, saw their sovereign debt spreads balloon in January as investors were gripped with fear of a contagion spreading across the markets. Credit default swap (CDS) spreads on all the main insurers widened between December and February (see graph, page 12) in response to the crisis.

The market reaction was hardly surprising given the amounts of government bond assets traditionally held on insurers’ portfolios. Société Générale published figures in February showing the allocation to Piigs government securities for nine of the major European insurers which, at that time, stood at anywhere between 12% of shareholder equity to as much as 247% of shareholder equity for Italian giant Generali (see table 1, page 12).

Estimates of mark-to-market losses on the portfolios of major insurers in Piigs countries so far remain relatively small, ranging from E153 million (£138.4 million) at Allianz to E23 million at Generali, according to JP Morgan.

But the potential for greater losses in the case of a deepening crisis is worrying. SocGen drew up a table highlighting the theoretical decline in the capital adequacy ratio assuming a 10% drop in the fair value of Piigs bonds for a number of the largest insurers.

The figures paint a startling picture of what could happen (see table 2, page 13), with potential capital adequacy ratio declines of 11%, 17.4% and 23% for three of the largest European insurers, Allianz, CNP and Generali respectively. While rating agencies have not, so far, taken any wholesale actions on the back of insurer sovereign debt exposure – indeed, only one major European insurance company, Fortis-owned AG Insurance, was given a negative ratings watch as a result of its high exposure to Greek government bonds last December – there is no doubt the industry is taking the situation seriously.

During its annual results conference in late February, Allianz’s chief financial officer (CFO), Paul Achleitner, sought to quell fears of the potential risks attached to its Piigs exposure stating “there was no risk of default in sovereign situations in Europe”, and that “anyone who is massively speculating on breaking up the euro should have a serious evaluation of what they are doing”. Yet just a month earlier, at the international Davos World Economic Forum, Achleitner had admitted there might be some Greek debt restructurings that could lead to write-offs for Allianz. The company currently has around 30% of its overall €130 billion government bond portfolio invested in the Piigs countries, of which the largest proportion, 20%, is in Italian sovereign bonds. Other insurers have also been at pains to disclose their exposures to southern European debt during the past couple of months, a move they haven’t often made in the past.

In February, French insurer Axa stated that its overall exposure to the Piigs countries at the end of 2009 was around E9.6 billion out a total portfolio of E150 billion. “This is very comparable to the previous year’s figures,” says a company spokesman. “It’s a long-term business, so we don’t buy or sell very frequently.”

Amsterdam-based ING insurance has a E5.7 billion exposure to Piigs countries of its overall E41 billion government bond portfolio. Aviva, in turn, has “only” £500 million of Greek debt exposure of its total £16.9 billion government bond portfolio, according to CFO Pat Regan speaking at the company’s annual results presentation in March.

But the insurer most severely exposed to the larger Piigs countries is Generali, with its E114 billion government bond portfolio containing E39 billion of Italian paper – an amount equal to about 250% of its shareholder capital.

The concentration in the Italian market is an obvious by-product of Generali being one of the few large ‘national champions’ in the Piigs states. SocGen estimates that in an extreme theoretical scenario, a 40% cash loss on Italian government securities would eliminate all of the Trieste-based insurer’s capital.

Material danger
The sovereign issue blew up last November when Greece announced it was running a 12.7% budget deficit, one of the highest in the Eurozone, which led to the three main rating agencies downgrading its sovereign credit rating. While the worries over sovereign credit quality have calmed since then, the long-term implications for insurers remain serious, says Andrew Balls, London-based managing director and head of European portfolio management at Pimco, which manages the majority of Allianz’s E925 billion of third-party investment assets.

“In the past insurers have had to evaluate interest rate and duration risk on a sovereign, but now they are having to look at credit risk as well, which is a new, but material danger,” Balls says.

The doomsday scenario would be a default in Greece leading to a loss of confidence and potential defaults in the other Piigs states. Analysts believe that with Greece, Ireland and Portugal, where the insurers have only very limited operations relative to their size, the parent companies would bail out local carriers in order to limit reputation risk. Exceptions to this would be CNP, which has a reasonable exposure to Portugal, and Aviva and Standard Life, which have large operations in Ireland. The other two Piigs countries are another story.

“Spain and Italy are in a different league,” says Roetger Franz, London-based insurance analyst at SocGen. “A full writedown of government securities, though highly unlikely, would be too big for bailouts by some parent companies. It would result in the insolvency of at least some of the local carriers because regulatory barriers limit capital transfers to foreign subsidiaries if they have a detrimental effect on policyholder interests.”

And it’s not just the sovereign bond portfolio that the threat comes from. A default or ratings downgrade in any individual country would inevitably have repercussions on insurer corporate bond holdings. In February, Fitch published a report highlighting the potential negative impact of a sovereign downgrade on the underlying corporate market, suggesting that in the case of a Eurozone default “the position of corporates [in that country] would most likely be weakened relative to their peers in non-defaulting jurisdictions, and this would likely be reflected in downward rating actions”.

While the situation is not as dire as it may seem – the agency cut the ratings on four major Greek banks following Greece’s ratings downgrade last December, but the rest of the corporate sector was left largely untouched – the issue has raised concern for insurers with large concentrations in particular countries. “The European sovereign debt crisis has forced people to wake up to the general issue of how you treat asset classes,” says Thaddeus Nyahasha, group solvency director at Aviva. “From our perspective, if we hold sovereign debt in another country, we stress it as if it was a third-party asset with the associated credit risks.”

Despite the clouds hanging in the air, most of the insurers that reported their figures this year stated they have little plans to significantly reduce their allocation to the Piigs countries. So far, analysts say, only Fortis looks likely to make any significant cuts to its Piigs exposure, though this comes on the back of the December ratings watch from Fitch.

“AG Insurance’s exposure to Greece was considered by Fitch quite high compared with other companies’ in December,” says Vanessa Andre, a director in Fitch’s insurance team. “Its exposure to Greek bonds has allowed it to gain spread, which became difficult given the dearth of opportunities out there. It was also thought that Greece was in Europe so it shouldn’t be too risky, but of course it is. But it does have ambitions to reduce its exposure to Greek bonds and increase its exposure to better rated government bonds, which should decrease its concentration risk.”

Spread gains
The potential spread gains to be made from Greek government paper may go some way to explaining why Zurich-based Swiss Re actually raised its allocation to Piigs bonds between October and December last year. The largest proportion of this was allocated to Greek debt, which rose from Sfr110 million (£68 million) at the end of September last year to Sfr482 million at the end of December.

A spokesman refused to comment on what kinds of liabilities had led to the growth in Greek bond investment beyond saying these transaction offer “an optimal match to Swiss Re’s liabilities”. However, the increase in this part of its portfolio is focused on short-term, two-year bonds, which should certainly afford it a decent pick-up as spreads on Greece contract in line with a more stable fiscal situation. Certainly the concentration towards Piigs countries should see improved performance for many insurers who might have invested as spreads widened towards the end of last year. And the impact is also likely to accrue on non-Piigs allocations.

“For some a continued crisis might be beneficial if the risk-free rate (Bund) rose to 4% from 3.2%,” says Michael Huttner, insurance analyst at JP Morgan. “It would make paying for liabilities easier for the likes of Munich Re or Allianz, the latter of which has E120 billion of liabilities at the guaranteed rate of 3.4%. But that is only if this is a slow-burner crisis.”

Currently, there are no huge incentives for insurers to reduce their sovereign portfolios. Indeed, new Solvency II proposals being considered are likely to see the opposite occurring. Under the initial draft proposals, issued by the Committee of European Insurance and Occupational Pensions Supervisors (Ceiops), insurers were advised that they would have to discount their technical provisions using triple A-rated government bond yields that had been designated as the risk-free rate. If this ruling goes through in its original state, it could lead to a massive flow of investment towards higher-rated country debt in the future, participants say.

“If these guidelines come into place we might see a situation where there is a big sell-off in European corporate and lower-rated sovereign debt to triple A-rated government bonds,” says Bruce Porteous, head of Solvency II and regulatory development at Standard Life in Edinburgh. “This could lead to concentration risks and may cause funding issues in lower-rated countries such as Greece, which would inevitably face a greater struggle to bring its paper to market.”

Last March, the Ceiops taskforce seemed to soften its stance by reaffirming the use of the swap-curve as the basis for the risk-free rate. While there are still dissenters – for instance, regulators in markets where the swap rate may be underdeveloped – this may be one step in the right direction.

Solvency II also encourages insurers to hold sovereign debt in their local currency since these assets are considered to be currency risk-free and hence not subject to the spread risk charges – the description of short-term, mark-to-market movements in bond spreads – that apply to similarly rated corporate securities.

Knock-on effect
The focus on local currency sovereign debt is certainly a prevalent concern for multinational insurers and may itself lead to future concentration risk, argues Porteous. “A lack of diversification and focus on own-country bonds, is potentially a bad thing,” he says. “If something went wrong with the German economy, this could have a knock-on effect on UK insurers, much more easily than if they had a portfolio spread across the market.”

However, Aviva’s Nyahasha says companies should not necessarily look to diversify just to spread their sovereign risk. Focusing on domestic markets is a natural by-product of an insurer’s business and this doesn’t always have a direct bearing on risk concentration.

“Quantitative impact survey four (QIS 4) tested a simplified approach to assessing credit risk exposures to sovereign debt,” he says. “The approach did not require insurers to stress sovereign debt in their local currency. There is a high correlation in the movements of particular countries we operate in, so the diversification element is less important. There is a definite argument for diversification, but you have to look at it in the greater scheme of things such as what is your interest rate risk exposure, your equity risk and so on.”

For now insurers are predicating their investment stance on the theory that none of the countries they hold bonds in actually defaults. The argument is that, since they are asset and liability matchers, insurers hold their debt securities to maturity and short-term fluctuations in the value of these portfolios should not pressurise them to liquidate allocations. But as has been seen in the credit crisis, the short-term fluctuations of a financial institution can be all-important in deciding its fate. “Anything that is a negative, even if it’s on the profit and loss account, could potentially be a concern,” says Huttner. “The question is how deep is it and how long will it last?”

Of course, assuming a default in more than one of the Piigs countries is perhaps stretching things a little far. While each has its problems, the economies within this group run on very different lines. And with Greece successfully launching its E5 billion bond in early March, a large proportion of which was bought by UK and German insurers, it seems that, for now, the prospect of a Greek default in the near future is quite remote.

Nor, it seems, is there much threat to the corporate bond portfolio from further sovereign downgrades. “If Germany, the US or UK were downgraded then you would see a swathe of corporates being downgraded too,” says Simon Harris, London-based managing director for European insurance at rating agency Moody’s. “But given that the countries where you have seen sovereign downgrades don’t have huge corporate bond issuers, this has been less of a problem.”

Still, while default worries may have eased for now, the sovereign issue is unlikely to go away any time soon. “We do have long-term concerns,” says Mark Dowding, head of institutional fixed income, Europe, DB Advisors.

“This is Greek crisis number one – but in the long-term you could see a repeat of this situation. As bond investors, insurers are going to continue to invest in sovereign debt, so it’s hard to exclude this. But the long-term question is important – can you successfully see monetary union without greater political or fiscal union?”