Experts say the inclusion of a sovereign shock in the European Union-wide industry stress test, launched on April 30, could hit balance sheets badly as few firms currently hold capital against government bonds.

 

The tests, led by the European Insurance and Occupational Pensions Authority (EIOPA), are the first to be carried out using a Solvency II balance sheet, where assets and liabilities are valued at market value, meaning that market movements have an immediate impact on insurers' levels of capital.

 

Insurers that fail will not be automatically required to raise capital, but might come under enhanced pressure from supervisors in the run-up to Solvency II.

 

The test is divided into two modules. In the market risk module the resilience of firms will be gauged against two adverse scenarios in which shocks in equity or corporate bond markets are assumed to spread across the financial markets and hit government bond and property markets. The test assesses how firms would cope with asset values tumbling at the same time as swap rates being pulled down by ultra-loose monetary policy, causing the present value of future liabilities to spike.

 

In the second module, regulators will examine the impact of protracted low yields on the industry. Low interest rates increase reinvestment risk and also drive down discount rates. Concerns about this so-called 'Japanification' scenario have built over the past few months as some eurozone countries have been found to be experiencing deflation, forcing the ECB to consider a quantitative easing programme.

 

In the market risk module, firms are required to complete the exercise at a group level, but those participating in the low-yield exercise will have to provide figures for individual entities.

 

Full article (subscription)