Equity Solvency Capital Requirements - What Institutional Regulation Can Learn from Private Investor Regulation
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Equity Solvency Capital Requirements - What Institutional Regulation Can Learn from Private Investor Regulation Laurens Swinkelsa, David Blitzb, Winfried Hallerbachb and Pim van Vlietb a
Erasmus University Rotterdam – Erasmus School of Economics, Burgemeester Oudlaan 50, 3000 DL Rotterdam, The Netherlands.
b
Robeco, Weena 850, NL-3014 DA Rotterdam, The Netherlands.
E-mails: [email protected]; [email protected]; [email protected]; [email protected]
Solvency II has one standard equity solvency capital requirement for type 1 or developed market stocks (39 per cent) and one for type 2 or emerging market stocks (49 per cent). As such, differences in financial economic risk of stock portfolios within developed or emerging markets do not influence solvency requirements. This encourages risk-seeking behaviour by insurance companies, and could sustain or even create structural mispricing in the cross-section of stock returns. We argue to improve Solvency II regulation by aligning it with more sophisticated European regulation that is already in place for mutual funds. Specifically, we propose to multiply the standard solvency charge of 39 per cent with the ratio of equity portfolio volatility to broad equity market volatility. This 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, while low-risk stock portfolios require less. Our approach encompasses the existing distinction between emerging and developed markets, and reduces geography to just one of many potential sources of risk that should be recognised. The proposed approach gives better incentives to institutional investors, contributes to market efficiency, and is much less prone to regulatory arbitrage than the existing approach. The Geneva Papers (2018) 43, 633–652. https://doi.org/10.1057/s41288-018-0086-3 Keywords: capital requirements; equities; regulation; Solvency II Article submitted 30 September 2017; accepted 4 April 2018; published online 17 May 2018
Introduction Insurance companies and pension funds have to hold solvency capital such that they are very likely to survive adverse shocks in financial markets. Under Solvency II, the standard solvency capital requirement (SCR) for a diversified equity portfolio is 39 per cent for stocks listed in developed markets and 49 per cent for those listed in emerging markets. The equity SCR should contribute to the overall goal that the probability of bankruptcy over the next 12 months is below 0.5 per cent. The Solvency II requirements have been compulsory for European insurance companies since January 2016. Most European pension funds are subject to country-specific regulation, but these local frameworks tend to
The Geneva Papers on Risk and Insurance—Issues and Practice
634
resemble Solvency II in many ways, in particular with regard to having fixed equity solvency capital requirements. Developed equity markets are generally perceived to be less risky than emerging e
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