Regulator Q&A - Isvap talks sovereign default and Solvency II

Italy has the ignominious achievement of being dubbed one of the ‘Piigs’, and therefore a potential sovereign worry. But Flavia Mazzarella, vice-director general of Isvap, the Italian insurance regulator, says the industry is not affected by this uncertainty, nor the prevailing low interest rate environment. Theodora Tsentas reports

Life & Pension Risk: The Italian insurance sector escaped relatively unscathed from the global financial crisis - is the same true of the sovereign debt crisis?

Flavia Mazzarella: From a financial stability perspective, the Italian insurance sector has definitely been able to withstand the recent sovereign turmoil - in fact, the results from the impact of the crisis have been quite positive. However, we are aware that the challenges have not ended completely and we continue to be alert - mainly to prevent a spillover to the real economy. What is apparent is that the picture is continuously changing and, unfortunately, despite the large-scale measures adopted by the biggest financial institutions - the European Central Bank (ECB), the International Monetary Fund (IMF), or national central banks (NCBs) - to promote financial stability, the outlook is still unstable.

Jurisdictions that used ECB and IMF support rather than relying on the NCB, or instead undertook national rescue plans, are more prone to budget deficit and public debt risks. They also face risks related to the withdrawal of these measures. So, the Italian government's decision to adopt stricter measures to consolidate public finances (based mainly on the reduction of expenditures and the fight against tax evasion) - and not to engage in discretionary fiscal easing or in government financial guarantees - proved to be appropriate. This contained the national deficit below the European Economic and Monetary Union's average and stabilised the bond spreads despite the debt level, which undeniably remains significant. These policies allow Italy to avoid a possible knock-on effect related to the adopted rescue plans and have helped maintain a high level of confidence in Italy's ability to fully repay its debt.

LPR: How exposed are Italian insurers to sovereign debt?

FM: Government bonds form 51.6% of Italian insurers' investment portfolios - of which approximately three-quarters is invested in the domestic market according to 2009 data - meaning the contagion threat from further foreign sovereigns becoming distressed is kept in check. The remaining 25% exposure to government bonds is well diversified and no other national government debt exceeds 5%. As such, the exposure to so-called peripheral sovereign debt is insubstantial and the majority of Italian firms proved to have a solvency buffer well beyond the minimum required by our legislation.

Since the beginning of the financial turmoil in 2007, Isvap strengthened its supervisory activity in order to monitor the investment policies of Italian insurance undertakings on a monthly rather than quarterly basis and has conducted ad hoc surveys on exposures to sovereign debt from time to time to assess the ability of undertakings to absorb future shocks and evaluate their solvency capacity.

LPR: Do you think Solvency II regulations could prompt a wholesale move to liability-driven investment practices by Italian insurers?

FM: Until now, there has been no particular shift in this direction in our market. It is worth recalling that, at the moment, derivatives transactions are only allowed for hedging and prudent management in Italy.

The differences between the regulation in place and the forthcoming one are substantial: under Solvency II, undertakings will have to make their investment decisions ignoring the existing binding quantitative limits on the different asset categories, as is currently required under national legislation. In doing so, they must consider the global impact of those decisions on their capital requirements, under the ‘Prudent Man' principle. Therefore, the adoption of market-based valuation for assets and liabilities could potentially trigger portfolio reallocations for the Italian insurance industry primarily by pushing them from equities towards less capital-absorbing and volatile investments such as bonds.

Having said this, large insurers with sophisticated internal models may choose to widen the range of investment tools and may decide, for example, to close asset-liability mismatches by relying on derivatives or to make use of swaptions to hedge interest rate risk - but they'll have to clearly demonstrate the rationale behind this and the risk reduction through asset diversification to the regulator.

LPR: If the current low interest rate environment continues, will it cause a problem for the Italian life insurance sector?

FM: We are still monitoring this prolonged period of low interest rates, as it could
prove especially problematic for life insurers by affecting their ability to meet their long-term obligations for products with guaranteed interest rates. We haven't experienced problems so far, mainly due to some characteristics of national insurance legislation. Firstly, life assurance undertakings must establish sufficient technical provisions for the contracts in their portfolio to meet the commitments and any future expenses. Secondly, the Italian Insurance Code anchors the maximum interest rate to the 10-year government bond.

Moreover, Isvap determines the maximum interest rate for all contracts providing a guaranteed rate, which cannot surpass 60% of the average coupon on a 10-year government bond. For all with-profit contracts linked to segregated funds, Isvap regulation states that the undertaking pursuing life insurance shall evaluate whether a special technical provision for interest rate risk is needed. The average interest rate for a total portfolio of guaranteed products has been steadily declining as the maximum guaranteed rate has been reduced in line with the performance of government bonds.

This mechanism only applies to new contracts; therefore, problems may persist for products with a high interest rate guarantee sold several years ago. Indeed, generally speaking, in a low interest rate environment it could be difficult to finance these guaranteed returns, triggering a search-for-yield behaviour with insurance companies investing in riskier instruments.

LPR: Does the Italian insurance sector support the inclusion of 100% of value-in-force (VIF) - the estimated expected future profits gained from insurance policies - in Tier I under Solvency II?

FM: This is a very delicate political issue at the moment. What I would like to say is that I have seen some confusion on this point. The Solvency II directive says the vast majority of the difference between assets and liabilities (including VIF) should be treated as Tier I capital, but what Ceiops focused on in the fifth quantitative impact study (QIS 5) was EPIFP [expected profits included in future premiums] - only a part of VIF. Before taking a decision in this regard, we need a quantification for expected future profits in future premiums and of their impact on the stability of the market.

LPR: Are you happy with the level of participation in the QIS process by Italian insurers?

FM: Yes, we appreciate the market response. More than 80% of Italian undertakings have participated in QIS 5, which is much higher than the 60% average of EU member participation and the target threshold set by the European Commission (EC). The percentage of participation in terms of volume is even more significant, with more than 95% of premiums in the non-life sector and more than 97% of technical provisions in the life sector.

We are also quite satisfied by the participation of small undertakings in QIS 5 which largely contributed to the rise in total undertaking participation from 88 in QIS 4 to 134 in QIS 5, with 60 small undertakings partaking in the last study. Group participation has also doubled to 14 in QIS 5, which goes beyond the 75% EU Commission target threshold. This shows that the awareness of Solvency II issues is much more widespread throughout the market.

Isvap has contributed to the successful levels of participation in its efforts to communicate with insurance companies through conferences, letters and meetings - especially in the launch phase of the QIS process.

LPR: Do you think the industry will require significant increases in capital with the introduction of Solvency II?

FM: It is not a secret that the EU industry has been questioning the significant increase in the overall level of capital that will ultimately be required under Solvency II. What I can say at this stage is that the debate on the level of capital will benefit from the results of QIS 5, which will be available early next year. The fundamentals of Solvency II however, remain a solid strategy to assess and manage risks.

Looking at the Italian market, we are very confident in its capitalisation: under the current Solvency I regime, the solvency ratio - the ratio of assets to liabilities - for life insurers rose from 1.7 in 2008 to 2.0 in 2009. Similarly, for non-life, we have seen an increase from 2.6 to 2.8 in the same timeframe. We aim to preserve the current level of capitalisation and we're waiting for the QIS 5 results to be able to analyse and understand the impact on the Italian industry.

LPR: Do you have any concerns over the ability of Italian insurers to raise additional capital under current market conditions?

FM: I understand the difficulty of the new framework, but I think the first step undertakings must take when entering Solvency II is to evaluate correctly their risk profile and understand in depth the risks they are facing so they can understand the right way to raise capital.

LPR: Is there a possibility of a dual approach where international subsidiaries are fully prepared and local insurance companies are failing to cope with preparations, as is the case in Greece?

FM: I do not think a dual approach could fit in the Italian market. Isvap has avoided introducing a lot of specifications that could distinguish one group from another. The discussions we had with insurers during the QIS 5 exercise did not highlight any relevant differences between them.

The dual approach we aim to avoid is instead between small versus large insurers. Until now, small insurers have been on the periphery of the Solvency II process, but we have urged them to participate in QIS 5 to ready themselves for Solvency II and benefit from the assessment of their investments and resources. I think it is important to contribute to the simplification of the system instead of creating a different regime for a group of enterprises. This is why we strongly support initiatives to simplify the Solvency II calculations as much as possible.

LPR: Do you think you will see a wave of mergers and acquisitions, or closures of smaller insurance companies in Italy, as they try cope with the stringent requirements of Solvency II?

FM: I do not think that Ceiops' aim is to enhance the stature of larger companies. We believe smaller Italian insurers will be able to cope with Solvency II considering current attempts to simplify the calculations and the application of the principle of proportionality. In the long run, some restructuring within existing groups may happen but, at present, we do not view this as a significant issue within the Italian market. We are, however, working against Solvency II becoming an incentive for the consolidation of the market.