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Solvency II encourages risk-seeking behavior

Solvency II encourages risk-seeking behavior

02-10-2017 | Research
Solvency II regulation should prevent insurance companies from going bankrupt. However, it has unintended, potentially harmful consequences that could actually encourage insurance companies to take more risk. We propose a more effective approach, which aligns with European regulation already in place for private investors.
  • David Blitz
    David
    Blitz
    PhD, Executive Director, Head of Quant Selection Research
  • Pim  van Vliet, PhD
    Pim
    van Vliet, PhD
    Managing Director, Head of Conservative Equities - Pim van Vliet
  • Laurens Swinkels
    Laurens
    Swinkels
    Quant Equity Researcher
  • Winfried  Hallerbach
    Winfried
    Hallerbach
    Senior Quantitative Researcher
  • Solvency II is very blunt for equities, ignoring differences in equity risk almost entirely
  • It is counterproductive and can actually promote risk-seeking behavior
  • We propose a simple and better approach, in line with existing mutual fund regulation
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Since 2016, insurance companies in the European Union have to comply with Solvency II regulation. This Directive imposes equity solvency capital requirements. This means that insurance companies have to hold a capital buffer to survive adverse shocks in financial markets. Most European pension funds are still subject to local regulation, but these local frameworks tend to resemble Solvency II.

Under Solvency II the standard solvency capital requirement (SCR) for a diversified equity portfolio is 39% for stocks listed in developed markets and 49% for those listed in emerging markets. This SCR is adjusted up or down with a maximum of 10 percentage points, depending on the equity market’s past three-year performance. The equity SCR is intended as a means to keep the probability of bankruptcy over the next twelve months below 0.5%.

Two unintended, potentially harmful consequences of Solvency II

Solvency II has a different equity solvency capital requirement for developed market stocks (39%) percent) and emerging market stocks (49%). This makes sense, as there is a difference in financial economic risk between the two types of markets. However, differences in financial economic risk within developed or emerging markets are not taken into account. This has two unintended, potentially detrimental consequences:

  1. It encourages risk-seeking behavior by insurance companies
  2. It could sustain or even create structural mispricing of stocks

We will explain why. First of all, within developed or within emerging equity markets, the risk of each equity portfolio is assumed to be the same. If you assume that more risk should lead to more return, this regulation creates an incentive to buy more risky stocks. This can be seen in Figure 1, where we depict a low-risk (blue) and a high-risk (red) portfolio. Solvency II assumes the risk for each of these two portfolios to be the same as the market’s, as indicated by the blue and red circles. As a result, the Solvency II investor does not face a risk-return trade-off, but can choose the highest return regardless of financial economic risk. Instead of promoting prudency, Solvency II therefore encourages risk-seeking behavior.

Source: Robeco

This is linked to the second unintended consequence of Solvency II. If large enough pools of capital are exposed to Solvency II-type regulation, the price of high-risk stocks is driven up more than warranted by their economic risk, while the price of low-risk stocks is pushed down more than justified by their economic risk. This leads to lower future returns for high-risk stocks, and higher future returns for low-risk stocks. Investors only have an incentive to buy the low-risk stocks when their price has decreased so much that the relation between risk and return has become flat or inverse. Such a distortion between risk and return is indeed observed in practice, and is commonly referred to as the low-risk anomaly. Oversimplified regulation such as the crude Solvency II SCR framework may help create and sustain this anomaly.

Our proposal: learn from private investor regulation

We urge European regulators for institutional investors to improve Solvency II by aligning it with more sophisticated European regulation that is already in place for private investors in mutual funds. This would reduce the potential harmful unintended consequences from existing solvency regulation.

Specifically, we propose to multiply the standard solvency charge of 39% with the ratio of the company’s equity portfolio volatility to the broad equity market’s volatility. This is a way to capture a portfolio’s relative risk. The ratio will be above one for more risky portfolios and below one for less risky portfolios, meaning that high-risk stock portfolios require more solvency capital than the market, and low-risk stock portfolios less. In our proposal the distinction between developed (SCR of 39%) and emerging (SCR of 49%) stocks has disappeared. This is because our formula already accounts for this difference.

For the broad equity market we propose to use the MSCI World Index. For volatility, we propose to take the five-year volatility and review this on a quarterly basis. If the company’s equity strategy does not have a representative five-year history, we propose backfilling the equity return history with a representative alternative proxy return series, such as an index that follows a similar investment strategy.

Conclusion: representative, simple and effective

Our proposed approach encompasses the existing distinction between emerging and developed markets, and also takes into account many other potential sources of risk. It is a straightforward and cost-efficient way for asset owners to assess risk, which is already used in regulation for European retail investors. It gives better incentives to institutional investors, contributes to market efficiency and is difficult to manipulate. In short, it reduces potentially harmful, unintended consequences of existing regulation for institutional investors.