European insurers, on the front line of the region's sovereign debt crisis because of their big exposure to distressed Italian bonds, will be forced to share losses with customers and rely on regulators to be lenient if Italy reneges on its debt.
Doubts over Italy's ability to service its loans this week pushed the yield on its bonds to levels seen as unsustainable, stirring fears the world's third-biggest debtor might default, and casting a long shadow over the insurance sector.
Leading insurers held about 151 billion euros (127 billion pounds) of Italian government bonds, Barclays Capital said in June, dwarfing their 8.5 billion euro exposure to bailed-out Greece, so far the biggest casualty of the sovereign debt crisis.
The sector's limited exposure to Greece has allowed it to easily absorb writedowns of up to 60 percent on its Greek bonds under a government-brokered deal in July. But it would face much bigger losses if Italy also renegotiated its debt.
Analysts say the full impact is hard to estimate as an Italian default could presage a break-up of the eurozone, triggering sharp falls across most asset markets, with sovereign and bank bonds issued in critically-indebted Spain, Ireland, Portugal and Greece likely to be hardest hit.
Bank and government debt from those countries plus Italy account for 14 percent of European insurers' investments and 101 percent of their shareholders' equity, credit rating agency Moody's said last month.
SAFE AND SOUND
At present, there is no call for insurers to take writedowns on their Italian bonds as there has been no event comparable to the Greek debt renegotiation to trigger impairments under accounting rules, industry sources say.
Many also see an Italian default as unlikely, arguing that investor confidence in the country's finances will be restored once a reformist government takes over from outgoing premier Silvio Berlusconi's administration.
Amongst insurers the likelihood of an Italian default is considered very low, said Barclays Capital analyst Claudia Gaspari.
The thinking is that in terms of underlying macro fundamentals, Italy actually looks quite good.
The industry has still been trimming its exposure to Italian government debt as a precaution, with Zurich Financial Services
But insurers are constrained from making more radical disposals because most hold Italian sovereign debt to fund payments to local policyholders, and have no substitute to fall back on.
This is particularly true of domestic Italian insurers, led by Generali
In the event of an Italian default, the industry's main line of defence would therefore be a temporary relaxation of solvency rules by accommodating regulators, analysts say.
BOND BUYERS NEEDED
Such regulatory forbearance, adopted as early as September by Italian insurance watchdog ISVAP, is partly designed to ensure the industry, which soaks up about 30 percent of government bond issuance, remains able to buy sovereign debt.
Regulators have alleviated the need for insurers to mark to market their domestic sovereign bond portfolios for regulatory accounting purposes, said Mark Oldcorn, head of European insurance at Goldman Sachs Asset Management.
This is due to the importance of these companies to the functioning of domestic capital markets, government debt financing, and a desire to maintain financial stability as much as possible.
Some pan-European insurers have repatriated peripheral sovereign debt to their subsidiaries in the issuing countries to make sure they get the full benefit of any regulatory lenience, analysts say.
Insurers would also be able to soften the blow of an Italian default by passing on some of their losses to customers.
This is because any default hit would be absorbed in part through life insurance funds which split investment gains and losses between policyholders and shareholders, with policyholders picking up as much as 80 percent.
French insurer Axa's 17.9 billion euro exposure to Italian sovereign debt falls to just 6 billion euros once so-called policyholder participation is taken into account, Barclays Capital said in June.
However, insurers' ability to pass on losses may be tempered by fears of losing customers to less seriously affected competitors, Goldman Sachs' Oldcorn said.
Italian insurers may face particular difficulties because their ability to share default losses would also be limited by an obligation to pay guaranteed returns to policyholders.
There are significant downward pressures on investment returns, and the closer you get to the guarantee, the lower the ability to share these potential losses, said Fitch analyst Federico Faccio.
(Editing by David Cowell)