LONDON (Reuters) - European insurers' share prices dropped yesterday on fears over their bond exposure following news that a unit of bond insurer Ambac Financial Group Inc lost a crucial "AAA" rating.

The DJ Stoxx insurance index was down 5.9 percent at its lowest for two years and making it the biggest sectoral faller in Europe.

"The big US monoline insurers are suffering at the moment and I think people are making a read-across to the European insurers," said one sector analyst.

Monoline insurers such as MBIA and Ambac — which insure against the risk of a bond or another security defaulting — have been hit by the sub-prime crisis, leading to fears that their problems could affect other financials.

The Ambac unit lost its top credit rating on Friday after the bond insurer scrapped plans to issue $1 billion of new equity. The group needs new capital after writing down repackaged consumer debt hit by the sub-prime crisis.

Investor fears have been raised by an announcement from French-Belgian bank Dexia yesterday, which said it and its bond insurance unit FSA have indirect financial exposure to Ambac totalling billions of euros.

Swiss Re, which reinsures the business of the US monoliners, was hardest hit among Europe's insurers, losing 9.4 percent by 11.51 GMT, to change hands at 69.20 Swiss francs.

Also weighing on the stock was the fact that UBS cut its target price on the stock to 80 francs from 88 francs, because of the risk of further writedowns on its sub-prime exposure.

"We have lowered our 2008 earnings by 500 million Swiss francs ($453.7 million) (pre-tax) on the assumption of material losses on the 1.7 billion franc subprime portfolio," UBS said. Swiss Re in December said it had 2.8 billion Swiss francs in exposure to monoline insurers, 17 percent of which with Ambac. Of the total exposure, 1.7 billion francs was subprime.

Other stocks were also hard hit, with Allianz 9.1 percent weaker, ING Groep down 9 percent, Zurich Financial 5.5 percent off and Standard Life falling around 7 percent.

But the sector analyst said the insurance sector was now oversold: "I think it is completely incorrect as the European insurers have very little exposure to the monolines," he said.