The Eurozone is experiencing instability that could threaten its very existence. As the possibility of a break up edges ever closer, insurers and other financial institutions must be ready to act, explains Robert Hall.
Recent political events in Europe have only heightened the uncertainty about how, when or if the economic instability in the Eurozone will end. But even if the Eurozone survives this immediate period intact, the turbulence is likely to recur.
The formation of the Eurozone took many years of managed convergence of exchange rates and interest rates. In contrast, the breakup could be swift and brutal.
The ultimate departure of a country from the Eurozone could happen overnight or over a weekend while financial markets are closed, albeit after a period of economic instability.
The process would inevitably cause enormous economic disruption. The value of equities and property might decline, and credit spreads on bonds and measures of actual and implied volatility could rise.
While the same might be said for natural disasters, political uprisings and military conflict, there are distinct features of a Eurozone breakup that permit mitigating actions to be taken in advance.
The particular consequences of a Eurozone breakup would depend on the manner in which it occurred. One possibility is that weaker countries ‘fall out of the bottom' so that their currencies can be devalued and competitiveness restored.
But it is also conceivable that stronger countries could ‘leave the top' to avoid potential fiscal transfers and subsidies to weaker members necessary to retain the Eurozone's integrity.
The euro might appreciate against the newly adopted currencies of weaker departing countries, but if stronger countries leave the reverse might be true.
Equally, a breakup could occur gradually: the departure of one state prompting markets to move, falling domino fashion against the next weakest member and ultimately forcing it out as well.
Alternatively, a group of countries could abruptly leave. A key issue in more radical scenarios is whether or not the euro continues to be used in any country over the long-term.
In these scenarios, where the euro effectively ceases to exist, there will be additional uncertainty in interpreting some contracts denominated in euros.
The legal principle of lex monetae is important in the event of a breakup. Broadly, a country has the legal right to define the currency in which contracts under its jurisdiction are denominated.
This principle is used often, such as when countries originally replaced their national currencies with the euro back in 1999.
A Eurozone country could enforce a change on contracts within its jurisdiction from the euro into a ‘new drachma', ‘new lira' or ‘new deutschemark', or other new currency as appropriate.
At the point of transition, the exchange rate from the euro to the new currency would be fixed, but the new currency would immediately be able to float up or down relative to the euro.
Capital controls would be likely to be introduced. If a weaker country were to leave the euro, it is likely that it would also seek to impose controls on assets within its jurisdiction to prevent capital fleeing the country.
Also potentially affected would be contracts explicitly denominated in euros but issued subject to law in a non-Eurozone jurisdiction.
While the outcome depends on the specifics of contracts, they may continue to be denominated in euros while the euro exists, regardless of events in the jurisdiction of the counterparties.
If the Eurozone breakup was more radical and the euro ceased to exist, the situation would be more complex. An attempt would probably be made to find a relevant substitute to the euro on which to base the contractual terms.
This treatment by non-Eurozone jurisdictions is important because English and US law is often used for international transactions and in establishing standardised contract terms for insurance transactions and investment instruments.
Another important point is to identify the legal jurisdiction under which assets and liabilities are denominated. A counterparty's jurisdiction may affect credit default risk, but the legal jurisdiction is important for managing currency redenomination risk.
While a contract's structure also plays a role, it is usually preferable when liabilities and covering assets are subject to law in the same jurisdiction or, where different, liabilities are subject to law in weaker Eurozone countries and assets in stronger ones.
Although this may seem straightforward, the details make it more complex. For a non-life insurer writing indemnity business, the currency redenomination risk of the insurance contract may be limited: rebuilding a house damaged by fire is likely to cost the same regardless of the currency in which the repair bill is paid.
Similarly, most life and pension policies that have benefits linked directly to the performance of investments have limited currency redenomination risk, unless there are investment guarantees or significant settlement periods for claims or premium receipts.
However, this is not the case for contracts with specific monetary benefits or investment returns denominated in euros, where the currency redenomination risks may be acute.
When reinsurance is used, some care may be needed to ensure that the reinsurance treaty provides the required hedge if the underlying direct insurance contracts experience a forced redenomination.
For assets, hedging instruments may need review to identify their ability to continue to provide a hedge in the event of a forced redenomination of the hedging instrument or the underlying positions it was meant to hedge.
Prior to the euro's formation, it was not uncommon to see contracts referring to ‘currency X or other such successor currency of country Y'. Such clauses may again be included in future insurance contracts to reduce the uncertainty associated with currency redenomination risks.
Eurozone instability is probably here for the long-term. It is likely to flare up again even if the immediate fears subside.
A breakup would cause widespread economic damage, although many of the effects would be similar to those from many other possible sources of economic turmoil.
In the event of a breakup there is the additional concern of capital controls and forced redenomination of the currency of assets and liabilities, leading to possible risks of illiquidity of assets and currency mismatching between assets and liabilities.
In this case, legal jurisdiction of assets and liabilities would become more significant as a Eurozone breakup becomes more likely and the risks of the imposition of capital controls and currency redenomination and mismatching increase.
To ascertain and mitigate this risk, firms need to identify the legal jurisdiction and contractual form of assets and liabilities, not just counterparties' countries of origin.
They should also reduce the mismatches between assets and liabilities and between hedging contracts and the underlying exposures being hedged that might arise from differences in their treatment in the event of forced redenomination of currencies.
If mismatches from contingent redenomination risks are unavoidable, it is advisable to hold liabilities in weaker states and assets in stronger states, treating non-Eurozone jurisdictions as a mid-range for this purpose.
The impact of possible imposition of capital controls should be minimised by limiting the amount of capital and assets held in weaker Eurozone countries.
Companies can test the impact of currency redenomination risk with multiple scenarios such as a partial or complete Eurozone breakup, including the exit of both weaker and stronger countries.
For insurers it is particularly important to consider alterations to contracts to clarify how these would be interpreted in the event of a Eurozone breakup.
All contracts - including employment, leases, assets and hedging instruments, reassurance and insurance - should be reviewed for potential Eurozone breakup implications.
Robert Hall is a director in the risk consulting and software division of Towers Watson.
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