Insurers’ investments may become unhealthily skewed toward Euro sovereign debt over corporate bonds because of Solvency II, experts have warned.

Solvency II was written at a time when sovereign debt was considered a safe bet and therefore it treats it very leniently in terms of capital requirements.

This compares to tougher treatment for corporate bonds, which were historically more risky by comparison.

The rules need updating in the light of the Greek and Irish debt crises, which mean that Euro debt is a much riskier investment than before.

However European finance ministers may be inclined to hang back in tweaking the rules if they want to encourage investment in Euro debt.

Andrew Power, partner at Deloitte, said: “Under Solvency II government debt is treated as essentially risk free. Should that still be the case? I imagine it’s something they’re going to have to consider.”

“The European Union doesn’t want to discourage investment, whereas at the same time it’s a potentially non-economic situation. The principle of Solvency II is that the capital held reflects the risk involved. If that’s not true, it would be inconsistent with SII, and also inconsistent with the treatment of corporate debt.”

Corporate debt is weighed up for capital requirements based on its level of riskiness, while government debt is all treated the same. Insurers are currently required to hold the same capital for Greek debt, yielding, say, 16%, as for UK gilts yielding 4%.

The attraction of capital-light, high yielding debt could have a knock-on effect of starving the corporate debt market of funds.

Michael Wainwright, partner at Eversheds, said: “There is a risk that political considerations may lead legislators to tip the balance in favour of insurers investing in EU government debt and against alternative investments.”

This month’s The Knowledge takes a detailed look at Solvency II and what it means for UK general insurance. Click here to read it online or read our digital edition.