Working Paper No. 710
By Caterina Lepore, Misa Tanaka, David Humphry and Kallol Sen.
This paper examines how the interactions between the valuation regime and solvency requirements influence investment behaviour of long-term investors with stable liabilities, such as life insurers. Under limited liability, solvency requirements based on historical cost valuation encourage risk-shifting to the detriment of policyholders, while those based on fair value regime can induce procyclical asset sales. A hybrid valuation regime, intended to address these unfavourable outcomes, does not strictly dominate the other two regimes. But both fair value and hybrid regimes outperform the historical cost regime if the regulators can set the penalty imposed on insurers based on supervisory information about their asset quality, even if this information is imperfect.