OREANDA-NEWS. Momentum for Solvency II to reflect the risks that European insurers face from holding sovereign debt will help investors quantify and compare sovereign risk across the sector, Fitch Ratings says.

Sovereign risk is an important part of some insurers' overall risk profile, particularly for firms with significant operations in peripheral eurozone countries, such as Generali, Allianz, Aviva and AXA, all of which have significant businesses in Italy.

In a statement today, the Prudential Regulation Authority, which is overseeing the implementation of Solvency II in the UK, recognised that insurers holding sovereign debt may be exposed to related market risk, credit risk and basis risk - the risk that divergences between sovereign yields and the liability discount rate weaken their capital position under Solvency II. The PRA stated that insurers must include these sovereign-related risks, where material, in their internal models when determining their capital position under Solvency II.

The PRA's statement is a positive step. Volatility in the values of peripheral eurozone sovereign debt in recent years, and particularly Greek debt in recent weeks, has highlighted that existing regulatory capital metrics often disregard potentially significant sovereign risks. Until Solvency II takes effect on 1 January 2016, many of the existing insurance regulatory regimes across Europe are not particularly risk-based, and sovereign risks are typically not recognised until they materialise.

We believe capital metrics that are risk-based are beneficial to investors, helping them to better assess the risks they are taking. Likewise from a credit perspective - at Fitch, we measure insurers' capital adequacy primarily with our Prism factor-based capital model, which is risk-based and applies capital charges to sovereign debt according to rating level and duration.

European sovereigns are still considered risk free in the Solvency II standard formula for calculating capital requirements. However, the trend is clear, with the PRA's statement, and a similar statement in April from the European Insurance and Occupational Pensions Authority (EIOPA) indicating that it would monitor across Europe for consistent internal model treatment of sovereign exposure.

Insurers across Europe will be required to reflect sovereign risk if they use an internal model, and we believe this will be extended to insurers using the standard formula, perhaps through add-on capital requirements. This would avoid the same sovereign risk being treated by regulators as risky or not, based purely on whether or not an insurer is an internal model user.

Solvency II will shed new light on insurers' sovereign exposures and capital positions when it comes into force next year. Many insurers are already allowing for sovereign risk in their recent disclosures on capital positions, and any insurers whose capital positions are significantly weakened by Solvency II charges will most likely benefit from transitional arrangements buying them time to smooth the effects over several years. But while regulators will allow for the benefits of transitional measures, some investors may look through these benefits to judge insurers' capital positions on the 'fully loaded' Solvency II basis.