On the exposure of insurance companies to sovereign risk - portfolio investments and market forces On the exposure of insurance companies to sovereign risk -portfolio investments and market forces 1

Reproduction permitted only if source is stated. ISBN Non-technical summary Research Question In the course of the European sovereign debt crisis, sovereign risk has become one of the biggest threats to financial stability. We focus on the vulnerabilities of the insurance sector and investigate the following questions: Is domestic sovereign risk transmitted to insurers' default risk? Are insurers affected differently by sovereign risk than other sectors of the economy (i.e. banks and non-financial firms)? What drives the link between sovereigns and insurers? Contribution Despite the importance of insurance companies as financial markets participants, research on risk spillovers between sovereigns and the financial system have usually sidestepped the insurance sector. In our paper, we aim at contributing to a better understanding of transmission of sovereign risk to the insurance sector. Moreover, this is the first paper to empirically investigate the role of sovereign bond holdings in this context as well as alternative channels of risk transmission. Results and Policy Implications We find that domestic sovereign risk significantly increases insurer risk as perceived by markets. While this risk transmission is slightly smaller than for banks, it is substantially larger than for non-financial companies. We find that the difference to non-financial firms is due to insurers' large sovereign bond portfolios. These investments play a major role in risk transmission domestically as well as internationally through foreign sovereign exposures. Moreover, we document a bias towards domestic sovereign bonds and increasing concentration in European insurers' sovereign portfolios. The link to domestic sovereigns was stronger for those insurers that are classified as systemically important by the Financial Stability Board. Overall, our results suggest that risks arising on the asset side of insurers' balance sheets deserve greater attention. Market expectations of insurer default risk depend on the riskiness of the sovereign debt portfolio of the insurer. However, in many cases, insurance regulation, including the new Solvency II regulation in the EU, exempts domestic government bonds from the calculation of the solvency capital requirement. Nichttechnische Zusammenfassung Fragestellung Ergebnisse und Politikimplikationen Unsere BUNDESBANK DISCUSSION PAPER NO 34/2015 On the exposure of insurance companies to sovereign risk -portfolio investments and market forces 1 Robert Düllᵃ, Felix Königᵇ, Jana Ohlsᵃ Abstract A sovereign debt crisis can have significant knock-on effects in the financial markets and put financial stability at risk. This paper focuses on the transmission of sovereign risk to insurance companies as some of the largest institutional investors in the sovereign bond market. We use a firm level panel dataset that covers large insurance companies, banks and non-financial firms from nine countries in the time period January 1 st 2008 to May 1 st 2013. We find significant and robust transmission effects from sovereign risk to domestic insurers. The impact on insurers is larger than for non-financial firms and slightly smaller than for banks. We find that systemically important insurers were more closely linked to the domestic sovereign. Based on European data, we show that risks in sovereign bond portfolios are an important driver of insurer risk, which is not reflected in current insurance regulation (incl. upcoming Solvency II in Europe)