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The Actuary The magazine of the Institute & Faculty of Actuaries

Italian insurers liable for losses on sovereign default

Based on its 'A+'/Negative rating of Italian sovereign debt, Fitch believes that Italian government bonds are a low default risk.

However, in the "extreme scenario" of a sovereign default, insurers will be liable for additional losses if the return on portfolios is below the minimum agreed, it said.

Life products offered by Italian life insurance companies typically distribute 85% of any investment return to policyholders and keep 15% for the company. In many policies, the absolute return cannot be less than a minimum guarantee that the insurer is contractually obliged to pay. If the investment returns are below this minimum, the insurer must pay the guaranteed return from its equity.

"The situation is worse for insurers in Italy compared with other jurisdictions, such as Germany, because there is not an explicit ability to defer profit sharing. This means there is no capital buffer from previous unrealised profits on the company's balance sheet," Fitch said.

"Historically, Italian companies built a cushion of unrealised 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 added.

The ratings service also said that in the unlikely scenario of a sovereign default, the realised losses on Italian debt holdings could damage insurers' capital adequacy to a larger extent than the traditional profit-sharing split would suggest. This is one of the assumptions underpinning its negative outlook on both the life and non-life sectors in Italy.

Theoretically insurers are also exposed to liquidity risk if policyholders start redeeming their policies early, although Fitch does not think this is a significant risk. The rate of policy lapse is around 8%, which Fitch believes is a structural feature of the market. Many policies are partially insulated from the risk through early redemption penalties.

Source: Insurance Insight