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27th November 2011

Sovereign bonds revised capital risk charges unlikely to be incorporated in Solvency II in near term says Fitch

Solvency II is unlikely to incorporate revised capital risk charges for European Economic Area sovereign bonds in the near term, as the European Commission will want to avoid any market disruption that this could cause, Fitch Ratings says.
The Commission is likely be sensitive to the fact that some financial market participants and commentators are questioning whether the euro will survive in its current form. Adding risk weights to some, but not all, eurozone member countries could be seen as acknowledging these concerns, and would potentially push a significant number of insurers currently satisfying the Solvency II capital requirements into the red.
The eurozone sovereign debt crisis has seen a number of market participants call into question Solvency II's uniform assessment of own-currency sovereign debt from the European Economic Area as risk-free with a zero capital risk charge.
However, the zero risk charge in the standard formula does not necessarily mean the risk is not taken into account by insurers. Many, especially larger, insurance groups use internal models to calculate capital which factor in risk capital for sovereign defaults. Capital increases, which can be added by regulators under Pillar II to reflect risk not captured in the standard formula, may also be imposed.
Crucially, moving to a mark-to-market balance sheet means that insurers are already largely factoring current market expectations for default and some of the illiquidity concerns. Given that an Italian 10-year bond is trading at 85% of face value and an Irish 10-year bond is trading at 78%, this already goes some way to factoring in the risks insurers are taking of default on the bonds. These adjustments flow directly into the solvency position under Solvency II.
Calls for a rethink on the treatment of eurozone sovereign debt are understandable, and we think charges could be added if eurozone government bond markets stabilise. But it is unlikely that they will be incorporated into Solvency II in the near term.
With Solvency II due to take effect from 1st January 2014, the timeframe for adding charges before this date is tight. But the Commission has been willing to make major changes to the charge structure and discount rate on corporate bonds without widespread testing, so it should not be assumed that introducing charges for sovereign bonds would automatically require another Quantitative Impact Study.