LONDON, Nov 11 (Reuters) – European insurers, on the front lineof the region's sovereign debt crisis because of their big exposureto distressed Italian bonds, will be forced to share losses withcustomers and rely on regulators to be lenient if Italy reneges onits debt.

Doubts over Italy's ability to service its loans this weekpushed the yield on its bonds to levels seen as unsustainable,stirring fears the world's third-biggest debtor might default, andcasting a long shadow over the insurance sector.

Leading insurers held about 151 billion euros ($205 billion) ofItalian government bonds, Barclays Capital said in June, dwarfingtheir 8.5 billion euro exposure to bailed-out Greece, so far thebiggest casualty of the sovereign debt crisis.

The sector's limited exposure to Greece has allowed it to easilyabsorb writedowns of up to 60 percent on its Greek bonds under agovernment-brokered deal in July. But it would face much biggerlosses if Italy also renegotiated its debt.

Analysts say the full impact is hard to estimate as an Italiandefault could presage a break-up of the eurozone, triggering sharpfalls across most asset markets, with sovereign and bank bondsissued in critically-indebted Spain, Ireland, Portugal and Greecelikely to be hardest hit.

Bank and government debt from those countries plus Italy accountfor 14 percent of European insurers' investments and 101 percent oftheir shareholders' equity, credit rating agency Moody's said lastmonth.

SAFE AND SOUND

At present, there is no call for insurers to take writedowns ontheir Italian bonds as there has been no event comparable to theGreek debt renegotiation to trigger impairments under accountingrules, industry sources say.

Many also see an Italian default as unlikely, arguing thatinvestor confidence in the country's finances will be restored oncea reformist government takes over from outgoing premier SilvioBerlusconi's administration.

“Amongst insurers the likelihood of an Italian default isconsidered very low,” said Barclays Capital analyst ClaudiaGaspari.

“The thinking is that in terms of underlying macro fundamentals,Italy actually looks quite good.”

The industry has still been trimming its exposure to Italiangovernment debt as a precaution, with Zurich Financial Services ,Munich Re and Phoenix Life between them offloading almost 4 billioneuros of the bonds during the third quarter.

But insurers are constrained from making more radical disposalsbecause most hold Italian sovereign debt to fund payments to localpolicyholders, and have no substitute to fall back on.

This is particularly true of domestic Italian insurers, led byGenerali, where much of the sector's Italian sovereign exposure isconcentrated.

In the event of an Italian default, the industry's main line ofdefence would therefore be a temporary relaxation of solvency rulesby accommodating regulators, analysts say.

BOND BUYERS NEEDED

Such “regulatory forbearance,” adopted as early as September byItalian insurance watchdog ISVAP, is partly designed to ensure theindustry, which soaks up about 30 percent of government bondissuance, remains able to buy sovereign debt.

“Regulators have alleviated the need for insurers to mark tomarket their domestic sovereign bond portfolios for regulatoryaccounting purposes,” said Mark Oldcorn, head of European insuranceat Goldman Sachs Asset Management.

“This is due to the importance of these companies to thefunctioning of domestic capital markets, government debt financing,and a desire to maintain financial stability as much aspossible.”

Some pan-European insurers have repatriated peripheral sovereigndebt to their subsidiaries in the issuing countries to make surethey get the full benefit of any regulatory lenience, analystssay.

Insurers would also be able to soften the blow of an Italiandefault by passing on some of their losses to customers.

This is because any default hit would be absorbed in partthrough life insurance funds which split investment gains andlosses between policyholders and shareholders, with policyholderspicking up as much as 80 percent.

French insurer Axa's 17.9 billion euro exposure to Italiansovereign debt falls to just 6 billion euros once so-calledpolicyholder participation is taken into account, Barclays Capitalsaid in June.

However, insurers' ability to pass on losses may be tempered byfears of losing customers to less seriously affected competitors,Goldman Sachs' Oldcorn said.

Italian insurers may face particular difficulties because theirability to share default losses would also be limited by anobligation to pay guaranteed returns to policyholders.

“There are significant downward pressures on investment returns,and the closer you get to the guarantee, the lower the ability toshare these potential losses,” said Fitch analyst FedericoFaccio.