The question of whether or not Europe has turned a financial corner remains unanswered. Europe has just experienced the biggest sovereign default in history – and the most anticipated. Greece’s recent orderly default was the first time a developed country has defaulted in six decades.
However, the final approval of the second €130bn bailout to Greece and the completion of the €206bn debt swap leading to a €100bn write off of debt was greeted by most in the financial markets with resignation. The mechanics of the deal were thrashed out for a number of months and most financial institutions had already written down Greek debt in preparation for a Greek haircut.
Collective action clauses
Close to 96 per cent of private bond holders were included in the €206bn debt restructuring following Athens’ decision to trigger “collective action clauses” (CACs) under the newly enacted Greek Bondholder Law, forcing a minority of bond holders to go with the majority decision to take up new bonds. The use of CACs triggered a “credit event” according to the International Swaps and Derivatives Association, which resulted in a pay out for holders of credit default swaps (CDSs) in the order of €2.89bn.
The triggering of CDSs has generally been seen as a positive development that will boost the eurozone debt markets, since a failure to trigger could have undermined use of the CDS as a hedging instrument for holding government bonds.
There is still a small minority of international investors whose bonds are covered by foreign (as opposed to Greek) law who are holding out from the restructuring. Whether or not these are bonds purchased by vulture funds or individual investors hold their nerve to force payment in full, possibly through the courts, remains to be seen. It may prove cheaper for Greece to pay the remainder of these bonds in full than fight costly litigation.
Some commentators believe that the target for Greece to reduce its debt-to-GDP ratio from 160 per cent to 120 per cent by 2020 may not be sustainable, given the challenges Greece is facing with residual debt of €250bn and a population fatigued by austerity measures in the fifth concurrent year of a contracting economy.
There is also concern about forthcoming elections in Greece and whether those elected will continue to adhere to the austerity measures to be implemented, on which bailout funds are dependent.
Many believe that it is only a matter of time before Greece requires a further bailout. Some believe that it would be better for Greece to default altogether and leave the eurozone. Others have turned their attention from Greece (which after all represents only 3 per cent of the eurozone economy) to speculate on which of the remaining PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) will experience the next default.
Portugal is, on paper, the next most troubled eurozone country but recent events in Spain, with strikes and demonstrations following significant cuts in public spending and tax rises, together with unemployment running at levels in excess of 23 per cent and continuing to rise, also cause concern.
Italy also has high debt but remains in better economic shape than Ireland, whose economy is slipping back into a recession, despite strict implementation of austerity measures.
Many believe that the eurozone is doing too little, too late to assist troubled peripheral eurozone nations to survive rather than doing more to stimulate their economies.
Available bailout funds are likely to increase from present €500bn levels (in addition to International Monetary Fund monies of close to €250bn) by allowing the temporary European Financial Stability Facility (EFSF) to continue in tandem with the European Stability Mechanism (ESM) which will be launched in July as a permanent rescue funding program. Indications are that the EFSF will stay in existence with the ESM, at least in the short term, leading to a €700bn fund but this stops short of the €1tr some economists advocate to restore confidence in the eurozone.
Implications for insurers
What does this mean for insurers? Instability is likely to continue for many months and years to come. A large number of insurers have already effected substantial writedowns on Greek debt over the past year, adversely affecting their profitability.
To date, however, it is believed insurers have not written down the debt of other PIIGS countries and if a further bailout for one of these countries were necessary or if they were to attempt a debt restructuring of a similar nature to that of Greece, there could be significant repercussions throughout the financial market.
In terms of casualties to date, the nationalisation of Dexia and the collapse of MF Global were both blamed on sovereign debt exposure. However, there have been few reported claims directly resulting from sovereign debt. The general economic malaise has led to claims being made by unhappy investors but fears sovereign debt could be the “next sub-prime” have not, as yet, come to pass.
There may potentially be a number of claims brought by disgruntled holders of Greek debt who have been forced into debt restructuring, who may claim they were badly advised. Whether such claims could be made good remains to be seen.
Optimists believe the worst is behind us with improved liquidity thanks to the European Central Bank’s long-term refinancing operation policy and the Fiscal Compact to be approved by January 2013, which aims to restore prudent fiscal policy in the EU.
The compact mirrors a number of principles of the Growth and Stability Pact implemented by the Maastricht Treaty, which were flouted by so many EU countries in the 2000s. Yet there is a perception the treaty will be ineffectual and all that is being done is papering over the cracks.
For example, Spain has, whilst signing up to the pact, already indicated that it will not be able to reduce its budget deficit to the target levels set for it and has simply rewritten its own target.
Minimising the risks
So what can insurers do to minimise their risks? Few Insurers appear in favour of imposing sovereign debt exclusions in their policies on the basis that to be effective they would need to exclude both direct and indirect losses and may be unworkable in practice with insureds refusing to accept them.
The tailoring of proposal forms to understand sovereign debt exposures of insureds and appropriate rating of risk would appear to be a sensible way of evaluating exposures but the future of the eurozone economy and exposures are very difficult to predict. Insurers, along with the rest of the financial markets, must wait and hope the eurozone has finally turned the corner.
This article was first published by Insurance Day on 26 April 2012.