Optimal equity protection of Solvency II regulated portfolios

Abstract

The Solvency II regulatory framework creates incentives for using derivatives to mitigate risk. However, for investors willing to reduce capital charges by protecting their portfolio against losses, very few practical solutions exist. In the context of equity investments, we examine the relationship between the cost of acquiring protection (in the form of a put option) and the reduction of capital charges that it entails. We develop the idea that Solvency II regulations introduce an external utility that modifies the economic value of options. Using these findings, we show that there is a way to choose protection levels that maximizes reductions in capital charges for every dollar spent on the put options. We provide results for both risk-based and drawdown-based capital requirements and argue that risk-based capital requirements offer even greater incentives for using derivatives in the context of risk mitigation.