Europe’s Solvency II legislation determines that sovereign bonds issued by European Union member states are exempt from capital charges relating to spread and concentration risk. This means that, providing they hedge against interest rate risk, insurers should treat sovereign bonds as risk-free assets.

 

Those who think this assumption is at odds with reality and that it ignores the lessons of the financial crisis are quietly starting to go beyond the rules. German insurance group Allianz is one of the firms leading this change. The firm started modelling spread risk for sovereign bonds at the height of the euro crisis for internal management purposes and, at the end of last year, it carried out a revamp of its internal model to include default and migration risk for sovereign bonds.

 

Tom Wilson, Allianz’s Munich-based chief risk officer, says sovereign issuers are now treated for internal management purposes in an equivalent way to corporates. This includes sovereign bonds held by domestic subsidiaries.

 

"We did an in-depth review of exposure to losses to see if there was a benefit in sovereign bonds held by domestic subsidiaries. Unfortunately, there is no reliable statistical evidence that supports that. We have found that sovereigns occasionally also walked away from their obligations even when they controlled their currency", he says.

 

Swiss insurance group Zurich is also improving its risk framework to mitigate the risks stemming from exposure to sovereign issuers. The insurer started to risk-weight its sovereign bond holdings after the crisis, but it held the capital at a group level. A more devolved strategy is being put in place as the group prepares for Solvency II.

 

“Business units that are using an internal model to determine the regulatory capital in Solvency II, such as our Irish business, will model default and market risk for sovereign bonds in the same way as those risks are modelled in our group model. Under Solvency II, we will hold the respective regulatory capital at those business units,” says Adrian Zweig, the firm’s Zurich-based head of risk analytics.

 

He explains that in the case of the business units that use the standard formula, only the capital required by the standard formula will be held locally. However, Zurich holds capital for market and default risk of all sovereign bond holdings. It maximises the capital held at group level to provide flexibility for deploying capital where necessary in case of a credit event or other large claim.

 

These improvements might appear common sense for an industry making a transition to a risk-based regime, but they amount to a revolution in the way insurers treat the risk on their asset portfolios – which are in no small part made up of sovereign bonds used to match liabilities.

 

Partly because central banks have the ability to print money and act as lenders of last resort, sovereign bonds have in the past been deemed low-risk investments. Prudential regulation has done little to encourage financial institutions, either banks or insurers, to hold capital against them. The insurance industry has never felt the need to do so either.

 

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