Implications of the Solvency II Regulations for Investment Incentives

Abstract

We analyze optimal investment incentives for a medium sized insurance company complying with the Solvency II regulations. Assuming that market investments are made independent of other operations, we find that the insurance company has incentives to increase investment in low stress factor equities. If the Solvency II standard formula stress test is a good estimation of the underlying risk, this leads to a reduction in risk taken by the insurance company. Allowing for reallocation of the market portfolio after reporting capital requirements decreases the risk reduction incentive. This effect may be mitigated by introducing transaction costs. At last we do not impose Solvency II restrictions on investment, but model the effect of supervisory intervention at a future date. This leads to risk reducing incentives for the insurancy company, contingent on the viability of the supervisory intervention threat.