Working Paper No. 664
By Graeme Douglas, Joseph Noss and Nicholas Vause
This paper provides a means of estimating how ‘Solvency II’ regulations - introduced in the European Union in January 2016 - might affect UK life insurers’ incentives to hold different types of financial assets, and how these asset holdings are likely to vary in the face of hypothetical changes to market prices. To do so, it sets out a structural model of firms’ equity to assess their investment behaviour under different regulatory regimes. It finds that, while Solvency II may partly protect insurers’ solvency positions from falls in risky asset prices, the new regulations might encourage certain types of UK life insurers to de-risk - that is, move to holding safe assets in place of risky - following falls in risk-free interest rates. This behaviour is driven by changes in the so-called ‘risk margin’, which, under its current design within the Solvency II framework, reduces insurers’ solvency positions following falls in risk-free interest rates, thereby encouraging them to sell risky assets to reduce their probability of regulatory insolvency. The model also suggests that, once Solvency II is fully implemented by 2032, UK life insurers may have markedly reduced their holdings of long-term, risky assets. In the model, this behaviour is also driven by the risk margin, which, by increasing the volatility of insurers’ solvency, encourages them to de-risk to reduce the variance of their asset portfolios.