Insurers face higher asset risk charges if Australia’s credit rating is downgraded, Nikko Asset Management has warned.

Senior Portfolio Manager Fixed Income Darren Langer says insurers would be affected due to the Life and General Insurance Capital (LAGIC) obligations introduced by the Australian Prudential Regulation Authority (APRA) in 2013.

“Given the potential for a significant increase in the LAGIC capital charge, we believe it would be in most insurers’ interests to enter into discussion with APRA about the consequences of a downgrade before it happens,” he said.

“At the same time, we think it prudent for insurers to be exploring the potential outcomes for their portfolios with their asset manager, as well as possible strategies for managing any changes.”

In July S&P Global Ratings placed a negative outlook on Australia’s AAA rating, implying a one-in-three chance of a downgrade within the next two years due to budget deficit concerns.

A downgrade would also have a flow-on impact on state and semi-government authorities and the domestic banks.

Insurers are required to hold prescribed levels of capital as part of wider financial system security measures. Riskier assets are penalised in calculations based on tier levels, with federal government debt at the top of the safety tree.

A downgrade could particularly affect insurer holdings of NSW, Victoria and ACT debt, while banks could also move from a Tier 2 to a Tier 3 counterparty grade risk, Nikko AM estimates.

“In terms of their day-to-day operations, it really changes very little, but unless APRA changes the way the capital charges are calculated then it will have an impact on how much regulatory capital they need to put aside if they want to maintain their existing portfolios,” Mr Langer told insuranceNEWS.com.au.

He says it is possible APRA could consider amending the ratings tiers after a downgrade, with S&P likely to clarify its view within the next year.

“It is not a problem yet. It is only if we get downgraded, and then it starts to become an issue, so it is still a fairly big ‘if’.”

S&P rival Moody’s today reaffirmed its AAA rating for Australia.