Solvency II and currency risk : an assessment of imposing solvency capital requirements from currency risk in Norway

Abstract

We assess the new EU directive for insurance companies, Solvency II, with regards to solvency capital requirement (SCR) from currency risk and its implications on risk management for Norwegian life insurers. The SCR is designed to offset losses during extreme market conditions. We question whether the direct adoption of the standard formula stipulated in the directive is reasonable for the Norwegian insurance market, as the Norwegian krone has historically had different characteristics than the euro. The parameter of interest is the input correlation factor between currencies and equities due to its impact on the SCR from currency risk through diversification effects. In the standard formula, this parameter is currently set to 0.25. We conduct this assessment by creating a back-testing model with a sample period from 2003 to 2015 for international equity portfolios with various hedge ratios and computing the corresponding SCR. To ensure quality and relevance we have based our assumptions in the model on information from interviews with five major life insurers in Norway. We find that a hedged portfolio underperforms its unhedged counterpart with respect to rate of return, volatility and, in particular, downside volatility. Downside volatility is what Norwegian life insurers mainly focus on because of the asymmetric payoff profile of their defined benefit pension products. By performing correlation and regression analyses, we find that the superior performance of the unhedged portfolio is caused by a predominantly negative correlation between the returns of the Norwegian krone (NOK) and international equity markets. This is due to the NOK’s risk-on characteristics, meaning that the currency is negatively correlated with the risk perception in financial markets. We thus argue that adopting the input correlation parameter from the standard formula is questionable as it contradicts these historical market dynamics. Furthermore, we find that the SCR from currency risk is significantly dependent on the input correlation factor, meaning that Solvency II will incentivize Norwegian life insurers not to lower their hedge ratios, and by doing so, might work against its goal of increasing financial stability.