For once, Fitch took the words right out of our mouth, and in the process reminded us that the time of the stupendously named ASSGEN CDS (357 bps, +41 today) is here (for our previous coverage on Generali, read here, here and here). And just because we like to live dangerously, we believe the time has come to knock on the door of the grand daddy of all: Pimco parent, German uber-insurer Allianz, where the crisis will eventually hit like a ton of anvils if and when things really get out of control. ALZ CDS + 12 at 136. Going much wider. After all, recall that the deus ex machina of the EFSF as a CDO Cubed came from, that's right, Allianz. So now that it has failed, guess who has the most to lose... If we had more time we would attach the recent Credit Sights piece on ALZ here, but we don't: we hope readers can track it down on their own.
FITCH: ITALIAN INSURERS CANNOT PASS ON ALL SOVEREIGN LOSSES
Fitch Ratings-London-09 November 2011: Contrary to what many commentators are predicting, Italian insurers may not be able to pass on most of the losses incurred from an unlikely default of Italian government debt.
Based on our '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, the ability of insurers to pass losses on to policyholders would be significantly impaired, as the return on customer portfolios may be below the minimum promised to policyholders. Insurers would be liable for the additional losses.
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.
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.
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 Fitch's Negative Outlook on the life and non-life sectors in Italy.
Theoretically the insurers are also exposed to liquidity risk if policyholders start redeeming their policies early. We do not believe this to be a significant risk. The rate of policy lapse is around 8% and we see this as a structural feature of the market. Many policies are partially insulated from this risk through early redemption penalties.