An Empirical Analysis of European Life Insurance Portfolio Regulations

Abstract

Insurance firms across EU member states are subject to capital requirements in order to reduce the risk of insurer insolvency and thereby protect policyholders and support market stability. Most countries supplement solvency capital requirements by regulating the portfolio of assets covering firms' liabilities. This paper looks at the different approaches in portfolio regulation of life insurance firms, in particular the regulations imposed on asset allocation with a view to mitigating investment risk. There are essentially two types of regulations which are applied across the world: Quantitative Restrictions (QR) which impose explicit limits on holdings in risky asset classes, and the Prudent Person Rule (PPR), which requires that firms invest prudently and follow broad principles of portfolio diversification and assetliability matching. We undertake econometric analysis to test the hypothesis that QR impose a cost on firms (and consequently on their consumers) in terms of riskadjusted returns. We find an economically and statistically significant impact of QR on portfolio returns for life insurance firms, of around 2-3 percentage points, adjusting for risk and controlling for other relevant factors. But the level of QR varies a great deal between countries. For countries with strong QR the returns of life insurance firms are reduced by 4 percentage points, whereas the returns of life insurance firms subject to weak QR are not statistically significantly different from those of firms subject to PPR. By imposing explicit limits on investment in risky asset classes, strong QR constrain portfolio diversification and distort portfolio choice, forcing firms to select portfolios below the efficient frontier. We note, however, that weak QR permit equity holdings much greater than those in practice held by life insurance firms subject to weak QR.