Equity Solvency Capital Requirements: What Institutional Regulation Can Learn from Private Investor Regulation

Abstract

Solvency II has one standard equity solvency capital requirement for type 1 or developed market stocks (39 percent) and one for type 2 or emerging market stocks (49 percent). As such, differences in financial economic risk of stock portfolios within developed or emerging markets do not influence solvency requirements. This encourages risk-seeking behavior by insurance companies, and could sustain or even create structural mispricing in the cross-section of stock returns. We argue to improve Solvency II regulation by aligning it with more sophisticated European regulation that is already in place for mutual funds. Specifically, we propose to multiply the standard solvency charge of 39 percent with the ratio of equity portfolio volatility to broad equity market volatility. This ratio will be above one for more risky portfolios and below one for less risky portfolios, meaning that high-risk stock portfolios require more solvency capital than the market, while low-risk stock portfolios require less. Our approach encompasses the existing distinction between emerging and developed markets, and reduces geography to just one of many potential sources of risk that should be recognized. The proposed approach gives better incentives to institutional investors, contributes to market efficiency, and is much less prone to regulatory arbitrage than the existing approach.