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Sovereign Concentration And Market Dynamics Intensify Risks For Italian Insurers

Table Of Contents
Competition And An Unfavorable Product Mix Weigh On Life Insurers' Operating Performance Volumes In Property/Casualty Are Set To Dip Investments: Sovereign Concentration Helps Yields But Generates High Volatility Capitalization Has Improved, But Remains Fragile Changing Regulation Could Lead To Stronger Capitalization Related Criteria And Research

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Insurance companies in Italy face higher credit risk than their counterparts in Western and Northern Europe, Standard & Poor's Ratings Services believes. The main reason, in our view, is high sovereign concentration, since Italian government bonds make up about 49% of insurers' investments, on average. We've also seen substantial volatility on insurers' balance sheets as Italian sovereign credit spreads continue to fluctuate. The outlooks on most of our ratings in the sector are therefore negative largely because of our ratings on Italy (unsolicited rating BBB/Negative/A-2). However, the outlooks also reflect our general view of Italian insurers as having generally weaker capital adequacy than their European peers. We think Italian sovereign concentration is set to remain high over the next three years, primarily for two reasons. First, in our view, solvency regulations encourage companies to hold government bonds. Second, the relatively high yields on Italian sovereign bonds partly shield domestic insurers from the effect of low interest rates. In particular, for life insurance operations, high yields mean good investment margins and prospects for stabilizing new-business margins. For property/casualty (P/C) insurers, the slowdown of economic activity in Italy has led to an overall reduction in the frequency of claims, and therefore also costs. Overview High returns and favorable capital charges under solvency regulation mean Italian government bonds will likely remain popular among the country's insurers, leaving industry ratings vulnerable to sovereign risk. Coming regulation could lead to product changes and benefit capitalizations, which albeit improved, remain weaker than those of other European insurers. Earnings should improve this year because impairments are unlikely to reoccur and underwriting profit in property/casualty keeps showing resilience as claims frequency decreases, but long-term recovery is yet to come. Weak GDP growth prospects and a shift toward single-premium life policies will likely constrain both life and non-life margins over the next two years.

We expect upcoming changes in regulation to influence developments in Italy's insurance industry, as they will in other parts of Europe. For instance, in the P/C sector, government measures to enhance policyholder protection could result in increasing customer turnover. Moreover, we believe Italian antitrust authorities will likely try to limit the pricing power of the largest insurers. On a much wider scale, the treatment of assets under current and future Solvency II regulation, in our view, continues to favor government bonds. This could lead to even higher sovereign exposure on insurers' balance sheets. Solvency II may also prompt substantial changes of participating life policies as insurers try to avoid increasing capital charges, which could help strengthen capital-management discipline. Overall, we consider the Italian insurance sector to have moderate industry and country risk. This reflects our view of

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the significant country risk of operating in Italy, risks from unpredictable settlements in the P/C sector, and increasing competition industrywide (see "Italian Life Insurance Sector Carries A Moderate Industry And Country Risk Assessment," and "Italian Property/Casualty Insurance Sector Carries A Moderate Industry And Country Risk Assessment," published on Nov. 12, 2013, on RatingsDirect). As of Oct. 31, 2013, we rate five Italian insurance groups comprising eight entities (see table 1). Together, the groups account for approximately 60% of the industry's gross premiums written (GPW). The average rating of 'BBB+' reflects the influence of the sovereign credit rating on Italy. However, Assicurazioni Generali's wide international diversification and our view of strong support for Allianz SpA from its German parent lift the average.
Table 1

Italian Insurance Industry--Long-Term Rating Trends 2008-2013


--Year ended Dec. 31-2008 Republic of Italy (unsolicited rating) Allianz SpA Assicurazioni Generali SpA Fondiaria-SAI SpA SIAT - Societa Italiana Assicurazioni e Riassicurazioni SpA Societa Cattolica di Assicurazione Unipol Assicurazioni SpA A+ AA AA ABBB AA2009 A+ AA AAABBB AA2010 A+ AA AABBB BBB AA2011 A AA AAB B AA2012 BBB+ A+ A BBB BBBBBB BBB 2013* BBB A ABBB BBBBBB BBB

*As of Nov. 1, 2013. Core operating entity of the Unipol Group since year-end 2012.

Competition And An Unfavorable Product Mix Weigh On Life Insurers' Operating Performance
We estimate growth in Italy's life insurance sector to have picked up substantially in 2013, but to be more in line with that of GDP in 2014 and 2015 (0.5%-1%). Volumes could still suffer from periods of high volatility in premium collections and policy lapses. Moreover, the high sensitivity of volumes to sovereign bonds' credit spreads, banks' liquidity, and relatively short policy maturities could exacerbate fluctuations in gross and net inflows. Nevertheless, trends we've observed this year suggest that the market will have expanded by 20% by year-end 2013, after a compound 25% decline in 2011-2012. In particular, participating contracts, which pay a stable return, are becoming attractive once again as banks seek to boost their placement commissions and because other investments, including government bonds, offer lower yields. A revival in equity markets is also fueling sales of unit-linked policies that are similar to investments. That said, the appeal of traditional participating policies products (known in the market as "Ramo I") to policyholders relies, in our view, on the returns and protection that minimum guaranteed rates provide. The average annual yield on such policies over 2008-2012 was 4%, from our estimates. Yet volumes would still be vulnerable to competition when interest rates are rising. This is because Italian households are likely to reallocate their savings among bank term deposits and government bonds. We've seen for example that new business declined by a compound 25% over

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2011-2012, while 2012 policy surrender rates were 11%, up from 7% in 2009 (see chart 1). These movements coincided with a sharp rise in Italian government bond yields, which reached close to 7% at year-end 2011 (see chart 3).
Chart 1

Furthermore, guaranteed surrender values expose Italian life players to losses on investments should lapses increase during periods of soaring interest rates. The relatively short effective maturity of such contracts intensifies the risk of outflows. We've observed that participating life policies in Italy had an average effective maturity of about six years in 2012, shorter than in other markets where insurers have large portfolios of this type of business, such as France, where tax incentives benefit policyholders only after eight years. In our view, these factors increase life insurance products' vulnerability to changing economic and financial conditions and will likely encourage insurers to change their strategies should they want to further differentiate their offers from bank savings. Competitive dynamics in the market also indicate to us increasing rivalry, as post office subsidiary Poste Vita gains prominence and financial advisers jockey for position in unit-linked business. Over the past five years, the combined market share of these two networks grew to 38.4% from 20% (see table 2), mainly at the expense of the bank and insurance agents distribution channels. Poste Vita--part of the Italian Poste group--now holds a market share of 15% of

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GPW, while financial advisers were able to attract a large share of the demand for unit-linked life products.
Table 2

Italian Life Insurance Sector--GPW By Source


--Year ended Dec. 31-(Bil. ) Banks Share of total (%) Poste office Share of total (%) Financial advisers Share of total (%) Agents Share of total (%) Direct Share of total (%) Brokers Share of total (%) Total GPW 2008 23.2 42.45 5.5 10.12 5.4 9.91 12.9 23.55 6.8 12.48 0.8 1.48 54.6 2009 40.1 49.46 7.1 8.74 13.1 16.20 12.9 15.90 7.1 8.70 0.8 1.00 81.1 2010 44.8 49.73 9.5 10.54 14.4 15.94 13.8 15.33 6.7 7.42 0.9 1.04 90.1 2011 30.9 41.84 9.5 12.87 13.6 18.39 12.1 16.38 7.0 9.47 0.8 1.04 73.9 2012 23.3 33.41 10.5 15.08 16.3 23.34 11.4 16.33 7.5 10.70 0.8 1.13 69.7

GPW--Gross premium written.

Changes in the business mix and low interest rates hamper profitability
After continuous declines over the past five years, new-business margins will likely stabilize this year at the relatively modest 2012 level--about 1.6% of the present value of new-business premiums--compared with 2.8% in 2008 (see chart 2). We expect that this will be mostly thanks to a recovery of sales of unit-linked and regular-premium contracts, which we anticipate, along with a modest rise in eurozone swap rates (see chart 3). We don't expect a meaningful recovery of new-business margins because unit-linked contracts and recurring premiums on participating contracts will likely remain well below precrisis levels. In addition, single-premium participating policies are still popular and interest rates remain lower than before 2008.

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Sovereign Concentration And Market Dynamics Intensify Risks For Italian Insurers

Chart 2

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Chart 3

Moreover, we believe the stabilization of margins may not benefit all Italian insurers evenly. In particular, we think most of the new unit-linked contracts will come from financial adviser networks. We also expect Poste Vita to increase its share of recurring new-business premiums. Several factors will likely continue to subdue insurers' profitability. First, the share of unit-linked business in life reserves decreased to 22% in 2012 from 36% in 2008 and could remain at this level given the attractiveness of participating contracts in volatile market conditions. We also expect high-margin recurring premiums to remain lower than in 2008 because the economic crisis has reduced Italians' propensity to save. On top of this, the 10-year swap rate (1.9% in 2012) has declined more quickly than the average guaranteed rate on policies (2% at in 2012), raising the market cost of guaranteed yields. Low swap rates will likely continue to constrain margins because we do not anticipate a material rise in long-term risk-free interest rates before 2015. To stabilize margins, Italian life insurers appear to have been gradually reducing guarantees on new contracts. The size of the reduction varies widely by group and could lead to diverging trends in new-business margins. We estimate that the guaranteed yield on new business in 2012 and 2013 was about 20 basis points (bps) to 30bps lower than on in-force contracts. In addition, the larger players now offer guaranteed rates close to market levels, but only at maturity. We believe these changes will sustain margins only in the medium term because in-force contracts generally

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provide more traditional cliquet guarantee structures (guarantees that accumulate year by year), which are less profitable for insurers.

Volumes In Property/Casualty Are Set To Dip


We believe economic and regulatory headwinds could lead to a further contraction of the P/C market by about 4% in 2013, after a 2% decline in 2012. This compares with the 1.9% decline we estimate for Italy's GDP over the same period. In our opinion, the slowdown will likely stem largely from declining tariffs on compulsory motor third-party liability (MTPL) insurance and lower demand for auto and commercial protection cover amid recessionary conditions. However, we expect business to decrease by an average 1% annually in 2014 and 2015 as MTPL business shrinks, while other business lines, in particular health and accident, should demonstrate higher resilience and mirror expected GDP growth of 0.5%-1%. Beyond economic conditions, the market is also undergoing major regulatory changes that are likely to have contrasting effects on growth. Notably, Italians are increasingly purchasing personal health and liability coverage to offset rising public health care costs and reduced government assistance. The widening of scope regarding mandatory professional liability insurance (for lawyers, architects, and tax advisers) could also sustain growth. On the other hand, the authorities continue to take actions aimed at enhancing policyholders' protection, which could increase competition. For example, the government has recently introduced a law prohibiting tacit renewals and imposing greater transparency on MTPL contracts. In addition, further market consolidation could alter the industry's competitive dynamics. With the restructuring of Generali's agency channels and the merger of Fondiaria-SAI with Unipol this year, these groups together make up close to 50% of P/C premiums. The enlarged entities would wield considerable pricing power, in our view, even if the authorities' monitoring of anti-competitive behavior were able to limit it.

Strong underwriting profits could weaken over 2014-2015


In our opinion, P/C underwriting performance will likely stay robust, but may lose ground over the next two years. We forecast the industry-average combined ratio to improve further, to a strong 93% in 2013 after 96% in 2012 (see chart 4). The combined ratio is the industry's most closely watched underwriting profitability metric; the lower the combined ratio, the more profitable, and a ratio above 100% signifies an underwriting loss. We believe the combined ratio will deteriorate only modestly to an average 96% over 2014-2015, owing to lower tariffs and demand, barring any major catastrophic event. However, that would still represent a significant improvement on the 103.7% we observed in 2009.

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Chart 4

The improvement in the combined ratio since then resulted from price increases, stronger reserving practices, and a sharp 30% drop in the number of claims between 2009 and 2012 (see chart 5). The decline in claims frequency stemmed mainly from the recession in 2011 and 2012, which translated into lower loss ratios. It remains to be seen how insurers' loss ratios will fare in light of our current expectation of a recovery to positive economic growth of 0.5% in 2014. We expect the frequency of claims on motor insurance policies to continue decreasing in 2013. Two reasons for this are lower disposable income and reduced motor vehicle usage (gasoline consumption was down 10% in 2012, according to Italian petrol distributors). In addition, insurers are implementing increasingly effective anti-fraud measures, in our view, and a change in law requires policyholders to provide medical evidence for smaller bodily injury claims, which account for about 80% of injury claims and 30% of the total cost. We estimate that this last measure has reduced the combined ratio by another 2%.

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Chart 5

Italian P/C insurers have modest exposure to catastrophe risk because such protection remains a generally underdeveloped market in Italy, in our view. The Italian Insurance Association (ANIA) estimates that the earthquake in Emilia Romagna in 2013 caused about 13 billion in damage, of which insurance companies bore just 1.5 billion of the cost (before reinsurance cover). This earthquake, which we regard as a rare occurrence, added only 2% to the industry-average combined ratio in 2012. Italian insurers have also generally continued to strengthen their non-life reserves. According to ANIA, in 2012 several companies increased their non-life reserves by 1 billion, thereby partly addressing what we regard as a historical weakness. Although such actions have put the industry's overall reserving on a more secure footing, we believe the risks have not disappeared completely. In particular, the cost of bodily injury claims could keep going up because the local courts still decide on the amount a claimant receives.

Investments: Sovereign Concentration Helps Yields But Generates High Volatility


A high share of Italian sovereign bonds protects domestic insurers from the drag on investment returns that most

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Europeans peers have suffered due to low interest rates. This concentration nevertheless heightens insurers' sensitivity to market volatility as well as credit risk. We also believe the level of investment is likely to persist, mainly because of attractive yields that make life insurance policies competitive, and a potentially beneficial Solvency II regulatory framework. We estimate that, as of year-end 2012, Italian government bonds represented 49% of the investments for which insurers carried their own risk and, including unit-linked life insurance policies, these totaled 226 billion (see table 3).
Table 3

Italian Insurance Industry--Investments By Asset Type


--Year ended Dec. 31-Percentage of total (%) 2 9 5 76 41 9 100 Percentage of total (%) 2 8 5 77 47 9 100 Percentage of total (%) 2 6 5 78 49 9 100

(Bil. ) Land and buildings Equities Mutual funds Fixed-income instruments of which Italian government bonds* Loans and deposits Total own-account investments Unit-linked and pension fund investments of which Italian government bonds* Total investments

2010 6.5 37.4 19.4 306.9 165 34.7 404.9 112.1 18 517.0

2011 6.9 33.0 21.3 316.0 194 35.2 412.5 98.9 16 511.4

2012 6.8 27.4 22.8 335.6 210 36.9 429.4 97.5 16 526.9

*The split between own account and unit-linked government bonds is Standard & Poor's estimate. Figures may differ due to rounding. Source: ANIA (Italian Insurance Association) and Bank of Italy.

Fluctuations in the value of assets backing insurance liabilities, mostly Italian government bonds, have seen insurers move from unrealized losses of 8% of liabilities at year-end 2011 to unrealized gains of 4% of liabilities in April 2013 (see table 4). The accumulation of losses has not prompted insurers to sell assets, however, because the possibility--under International Financial Reporting Standards--of maintaining the book value of assets considered held to maturity and backing life liabilities minimizes the impact of negative market value. In our view, this has reinforced the perception of Italian government bonds as a good match for life insurance liabilities, and insurers have increased their holdings over the past three years. We nevertheless believe that if interest rates increase and insurers face a long period of net outflows because of a rise in policy surrenders and a drop in new life business, they could be forced to sell investment assets at a loss.
Table 4

Italian Insurance Industry--Unrealized Gains And Losses On Insurance Assets


--Year ended Dec. 31-(Bil. ) Assets backing life liabilities Total assets 311.5 302.2 351.6 362.7 2010 2011 2012 April 1, 2013

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Table 4

Italian Insurance Industry--Unrealized Gains And Losses On Insurance Assets (cont.)


Unrealized gain/loss Gain/loss as a share of assets (%) Of which government bonds Unrealized gain/loss Gain/loss as a share of assets (%) Assets backing non-life liabilities Total assets Unrealized gain/loss Gain/loss as a share of assets (%) Of which government bonds Unrealized gain/loss Gain/loss as a share of assets (%) Source: ANIA (Italian Insurance Association). 77.0 1.5 2.0 22.1 (0.5) (2.3) 75.6 (0.8) (1.1) 22.2 (1.7) (7.8) 79.6 4.5 5.7 25.3 0.7 2.6 82.7 5.3 6.4 28.1 1.2 4.2 (5.4) (1.7) 177.5 (5.7) (3.2) (29.2) (9.7) 181.9 (22.2) (12.2) 11.7 3.3 224.7 7.5 3.3 17.8 4.9 229.1 13.0 5.7

We believe the volatility of surrenders and regulatory incentives have led Italian insurers to try to minimize asset-liability mismatches by investing in liquid assets with an attractive yield. In our view, Italian government bonds meet these requirements, in addition to benefitting from favorable regulatory treatment (see box below, titled "Italian Government Bonds Under EU Solvency Frameworks"). Long-term lending to corporations for infrastructure projects is a growing asset class for many European insurance companies, but these loans are less liquid than listed bonds and have longer terms. Consequently, Italian insurers might be reluctant to invest very large amounts in such asset classes. Insurers have also reduced their investments in the domestic banking sector to 6% of the total at year-end 2012, we believe, because such holdings have shown higher volatility than sovereign bonds. Italian Government Bonds Under EU Solvency Frameworks Within the Solvency I framework, the Italian regulator adopted Regulation 43 in 2011, a measure that widened the forbearance of market-value losses on government bonds to 30% of required capital and eliminated forbearance on other asset types under Regulation 28 in 2009. More importantly, under the forthcoming Solvency II regulations, government bonds will benefit from not having a capital requirement for default risk. Therefore, the capital charge for a long-term sovereign bond in the 'BBB' rating category should be well below that of a similarly rated corporate bond.

Capitalization Has Improved, But Remains Fragile


We assess the large Italian insurers' capital adequacy in the 'BBB' range, despite a slight increase in 2012. Capital bases rebounded in 2012 from historical lows at year-end 2011, thanks to narrowing credit spreads, better technical results, and lower asset impairments. In addition, Unipol and Fondiaria-SAI raised 2.2 billion in capital, representing 30% of

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the combined group's shareholders' equity. However, the contribution from the growth of participating life policies and deterioration of asset quality still weigh on our assessment of capitalization. Furthermore, we view capital adequacy in the industry as highly sensitive to market conditions. Prospectively, we expect insurers to post record earnings in 2013, which should sustain capital adequacy, assuming dividend payouts remain moderate. Following a strong performance in the first half of 2013 from the five largest insurers, which we rate, we project that, for the full year of 2013, these companies' aggregate net profit should exceed that of last year (see chart 6). Nevertheless, we think the rise in life insurance reserves in 2013 could dampen the positive effect on profitability. Consequently, we don't currently expect a strong recovery in capital adequacy. In our view, the relatively high cost of issuing debt also constrains Italian insurers' financial flexibility. So we expect the larger insurers, in particular, to continue focusing on asset sales and cutting back expansion to limit their future capital needs.
Chart 6

The capital charge for life insurance risk and for credit risk is generally higher in Italy than in neighboring countries--20% and 29%, respectively, of Standard & Poor's capital charges (see chart 7). In particular, the average rating on Italian insurers' fixed-income investment portfolios is 'BBB,' compared with 'AA' for those of German insurers

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and between 'A' and 'AA' for French insurers. On the other hand, Italian insurers' relatively small equity exposures and generally low asset-liability mismatches also mean market risk does not attract as big a capital charge as in some other countries.
Chart 7

Like asset values, credit spreads have also generated volatility in insurers' regulatory solvency ratios. The average consolidated solvency ratio of the five largest insurers we rate declined to close to 120% in 2011, including the forbearance of Regulation 43, from 130% in 2010 (see chart 8). We believe consolidated regulatory solvency ratios give a more accurate picture of solvency than those based on unconsolidated statutory reports. Statutory accounts, in our view, underestimate intangible assets, such as goodwill in affiliates.

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Chart 8

The absence of ample policyholder bonus reserves, which feature in other large European markets (such as France and Germany) that offer participating life products, limits Italian insurers' flexibility to absorb large shocks, in our view.

Changing Regulation Could Lead To Stronger Capitalization


We believe that Solvency II will have a wide-ranging effect on insurers, not the least of which will be on their credit profiles, possibly leading to more disciplined capital management. The Italian insurance regulator's test, early this year, of the application of Solvency II's long-term guarantee assessment as of Dec. 31, 2011, highlighted that without adjustments to solvency calculations, many insurance companies would have had to recapitalize. Corrective adjustments to measure Italian insurance liabilities in a Solvency II framework, such as the "volatility balancer" will be crucial for Italian insurers' future capital levels, in our view. Solvency II may also lead to substantial changes of participating life policies as Italian insurers try to avoid increasing capital charges. Abandoning cliquet guarantees could increase companies' capacity to absorb losses and reduce capital charges. Also, a change that links surrender values to the market value of assets, as exists in countries such as Belgium and Spain, could reduce losses related to mass surrenders if the market value of investments were to weaken.

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The negative outlook on Italy is the main driver of the negative outlook on most of the Italian insurers we rate. That said, the weak GDP growth prospects for Italy that are weighing on the country's fiscal indicators also pose medium-term challenges for the country's insurance industry. We forecast, in particular, property and casualty premium to decline over the next two years because the modest economic recovery is likely to be insufficient to offset lower tariffs and product demand. Moreover, declining incomes and savings will make it increasingly difficult for insurers to develop more profitable and longer-term unit-linked life insurance contracts. As a result, Italian insurers are likely to remain vulnerable to increasing competition in motor insurance and single-premium guaranteed life insurance contracts, which are their main product lines. Although, overall, profitability in the industry may show a recovery in 2013, we believe it won't be strong enough to improve capitalization according to our methodology.

Related Criteria And Research


Related criteria
Insurers: Rating Methodology, May 7, 2013 Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance Capital Model, June 7, 2010

Related research
Italian Life Insurance Sector Carries A Moderate Industry And Country Risk Assessment, Nov. 12, 2013 Italian Property/Casualty Insurance Sector Carries A Moderate Industry And Country Risk Assessment, Nov. 12, 2013 Two Italian Insurers Downgraded And Three Others Affirmed After Rating Action On Italy; Outlooks Remain Mostly Negative, July 12, 2013 Long-Term Ratings On Italy Lowered To 'BBB'; Outlook Negative, July 9, 2013 S&P's Insurance Industry And Country Risk Assessments Offer A Global View Of The Forces Shaping Insurance Markets, May 22, 2013
Additional Contact: Insurance Ratings Europe; InsuranceInteractive_Europe@standardandpoors.com

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