Solvency II and sovereign credit risk: Additional empirical evidence and some thoughts about implications for regulators and lawmakers

Techniques of time series analysis are used to examine 30 year government bond yields in Germany, France, Italy and Spain. The empirical evidence reported here seems to imply that fixed income markets have reacted to the recent economic and financial crisis in Europe by starting to price in a significant possibility of government debt defaults – which means that all of a sudden sovereign credit risk (and possibly even redenomination risk) have become of some importance in the process of determining government bond prices. Given that long-term fixed income securities are an important asset class for European life insurers the findings reported here could be of some importance for regulators and lawmakers because the newly introduced Solvency II insurance regulation framework ignores these risks with regard to the calculation of solvency capital requirements. Therefore, further work to improve the new regulatory regime might still be needed.