December 12, 2013 / 9:00 AM / 6 years ago

EU insurance watchdog highlights "cat" bond market risks

FRANKFURT, Dec 12 (Reuters) - A surge of new capital from investors like pension funds into the market for specialised insurance risks could threaten financial systems and needs to be closely watched, the European Union insurance watchdog EIOPA said on Thursday.

Low interest rates on traditional bonds have encouraged pension and hedge funds to pour money into insurance-linked securities (ILS) like catastrophe bonds and other securitised insurance investments to obtain higher yields and diversify away from financial market risks.

Catastrophe bonds are used by the insurance industry to transfer financial risks of extreme events like earthquakes or hurricanes to investors, who receive an annual return in exchange for agreeing to cover damages they consider very unlikely.

The European Insurance and Occupational Pensions Authority (EIOPA) said the increasing inflow of funds into the insurance marketplace expected over the coming years raised concerns, particularly if investors did not have the ability to analyse the underlying risks and complexity of the insurance market.

“Without adequate supervision, such developments could cause systemic risk,” EIOPA said in its twice-yearly financial stability report, adding that extensive use of ILS tends to cloud the picture in understanding risk transfer.

The watchdog also pointed out that while the ILS market was small relative to the overall securities and fixed income markets, its size was still significant compared with the market for property and casualty reinsurance.

“It will be interesting to see how these (ILS) vehicles will develop in size and perform when market conditions improve,” EIOPA said.

Many insurance observers have said the growth in insurance- linked securities could undercut pricing power at traditional reinsurers but big players like Munich Re, Swiss Re and Hannover Re have played down the threat.

INVESTMENT RULES

Faced with sluggish economies, some European politicians have urged regulators to ease restrictions on investments by insurers, so that their money could help keep growth ticking over.

Insurers like Europe’s biggest, Allianz, have said they would increase funds going into infrastructure or renewable energy investments if the rules were less onerous.

In its report, EIOPA said it was aware of the need to stoke growth but stressed that insurers must make sure their assets were diversified and well matched to future liabilities, to protect policy holders.

“Any amendments to the regulatory treatment of certain types of investments need to accurately reflect underlying risks and avoid concentration of risk exposures,” EIOPA said.

“Otherwise, policy holders may end up with insufficient protection which could ultimately impair their willingness to enter into long-term contracts,” it said.

The watchdog said that overall risks to the insurance sector were little changed from its report six months ago.

EIOPA identified the main threats to the sector as coming from low interest rates, a weak economy and potential contagion risks linked to the insurers’ exposure to government bonds and financial institutions, but said the financial position of insurance companies is relatively stable. (Reporting by Jonathan Gould. Editing by Jane Merriman)

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