Abstract
This paper develops a framework to examine how the interactions between the valuation regime and solvency requirements influence investment behaviour of long-term investors with stable liabilities, such as life insurers. The results contribute to the debate over market-based valuation regimes, and shed light on new hybrid regimes explored in policy circles. We show that solvency requirements based on fair value regime can induce procyclical asset sales, but those based on historical cost valuation encourage insurers to engage in risk-shifting to the detriment of policyholders. A hybrid valuation regime, intended to address these unfavourable outcomes, does not strictly dominate the other two regimes on its own. However, market-based regimes can be made effective, if regulators calibrate their responses to solvency breaches using supervisory information about insurers' asset quality.
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