The Geneva Papers, 2013, 38, (250–273)

r 2013 The International Association for the Study of Insurance Economics 1018-5895/13
www.genevaassociation.org

Will Solvency II Market Risk Requirements Bite?

The Impact of Solvency II on Insurers’ Asset Allocation
Dirk Höring
Humboldt-Universität zu Berlin, School of Business and Economics, Spandauer Str. 1,
10999 Berlin, Germany.
E-mail: horingdi@hu-berlin.de

The European insurance industry is among the largest institutional investors in Europe.
Therefore, major reallocations in their investment portfolios due to the new risk-based
economic capital requirements introduced by Solvency II would cause significant disruptions
in European capital markets and corporate financing. This paper studies whether the new
regulatory capital requirements for market risk are a binding constraint for European
insurers by comparing the required market risk capital of the Solvency II standard model
with the Standard & Poor’s rating model for a fictitious, but representative, European-based
life insurer. The results show that for a comparable level of confidence, the rating model
requires 68 per cent more capital than the standard model for the same market risks. Hence,
Solvency II seems not to be a binding capital constraint for market risk and thus would not
significantly influence the insurance companies’ investment strategies.
The Geneva Papers (2013) 38, 250–273. doi:10.1057/gpp.2012.31

Keywords: Solvency II; rating; market risk; capital requirements

Article submitted 15 March 2012; accepted 10 May 2012; published online 11 July 2012

Introduction
European (life) insurance companies are among the largest institutional investors
in Europe with more than EUR7.4 trillion assets under management in 2010.1
Therefore, the role of insurance companies in the financing of European sovereigns
and corporates is undisputed. However, insurance companies in the European
Economic Area (EEA) face probably the greatest regulatory reform they have ever
witnessed with the introduction of a new economic risk-based regulatory framework
called Solvency II, which might impact their investment strategies. Among other
measures, Solvency II introduces economic risk-based capital requirements for market
risks to capture the riskiness of different asset allocations.2 The question of whether
these new requirements will impact the investment strategies of European insurance
companies is heavily debated.
The ongoing political discussion is very well illustrated by a recent comment
of the European Commissioner for Internal Market and Services, Michel Barnier.

1
See CEA (2011, p. 28).
2
See CGFS (2011, pp. 25–26).
 Dirk Höring
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In a letter to the insurance industry, he writes: The criticisms levied against Solvency II,
particularly that the calibrations are excessively high, have not been confirmed by
evidence.3 A similar debate took place in the U.S. with the introduction of risk-based
capital standards in 1994. An empirical analysis of the effect of risk-based capital
requirements on U.S. life insurers’ investment portfolios by Petroni and Shackelford4
indicates that despite wide-spread expectations of major restructuring in the investments
of life insurers, our exhaustive set of tests generally fails to detect a response to the asset
risk component of RBC [risk-based capital] standards. The new Solvency II capital
requirements for market risk raise analogous expectations and concerns. For example,
the Committee on the Global Financial System (CGFS)5 states that they [the insurance
companies] may rebalance their asset portfolios in line with the new risk charges.
This paper studies the question of whether the new market risk capital requirements
outlined by Solvency II will significantly impact the European insurance companies’
asset allocations. It analyses whether these new requirements are a binding constraint
for insurers enforcing a restructuring of their investment portfolios and disrupting
European capital markets. It compares the market risk capital requirements of the
Solvency II standard model with the needs of the Standard & Poor’s (S&P) rating
model for a fictitious, but representative, European-based life insurer. The study
reveals that the rating model requires 68 per cent more capital for market risk than the
standard model for a comparable level of confidence mainly due to the high
diversification credits and loss-absorbing effects of technical provisions and deferred
taxes granted by the standard model. This result is robust for a range of different asset
allocations for the representative European-based life insurer.
The remainder of this paper is structured as follows. The next section locates the
paper within the context of previous literature. A section introducing the concept of
capital management by insurance companies follows. The section Methodology
describes the methodology and procedure used to compare the regulatory and rating
capital requirements in this paper. This is followed by a section presenting the
representative European-based life insurer. Results are provided in the penultimate
section and the final section concludes.

Literature review
Academic literature review
Researchers discuss the effects of introducing regulatory risk-based capital require-
ments on insurance companies’ investment portfolios for three case studies: U.S. RBC,
Swiss Solvency Test (SST) and Solvency II.6 Petroni and Shackelford6 empirically
investigate the effect of risk-based capital requirements on U.S. life insurers’

3
See Barnier (2011, p. 2).
4
Petroni and Shackelford (1996).
5
CGFS (2011, p. 1).
6
Please note, that references for both the SST and Solvency II are based on preliminary technical
specifications and calibrations subject to change over time limiting the applicability of the conclusions
for the current regulatory directives.
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252

investment portfolios. Their results show no strong evidence for a major restructuring
of investments into assets requiring low capital as a response to the introduction of
risk-based capital requirements for investments in 1994. Cheng and Weiss7 study the
investment behaviour of U.S. property and casualty insurers in response to the
introduction of risk-based capital requirements. The authors find that property and
casualty insurers in weaker financial positions adapt to the new regulatory require-
ments by adjusting their target ratio of leverage, their proportion of premiums written
in high-risk lines, and their proportion of stock and real estate investments.
Eling et al.8 discuss the implication of the SST for Swiss insurance companies’ asset
and liability management, corporate financing and product design based upon a study
by Schmeiser et al.9 The study is based on preliminary specifications according to the
third version of the SST market risk model as of 2006. The authors conclude that the
SST will motivate insurance companies to shift towards long-term bonds to reduce
their duration gaps. Furthermore, insurers are expected to increase rating quality of
their bond portfolio and to reduce their real estate exposure. Eling et al.10 note that
many insurers already fulfil the capital requirements due to binding capital constraints
from their own internal model or due to their desire to satisfy rating requirements.
Several authors discuss the implications of Solvency II for the investment strategies
and policies of insurance companies in the EEA either in general or in combination
with the effects of the implementation of the new Basel III regulations for banks.
Rudschuck et al.11 argue that the new risk-based capital requirements according to the
specifications of the fourth Qualitative Impact Study (QIS4) will force life insurance
companies to reduce their equity exposures. Van Bragt et al.12 simulate the results
of the QIS4 parameterisation for a typical life insurance company for different
investment policies. The authors find that the asset allocation and asset duration have
a major impact on the regulatory capital requirements. Moreover, their simulation
indicates that duration matching changes more efficiently the risk and return profile
of the investment portfolio than reducing the equity exposure. The CGFS study13
analyses the effect of accounting and regulatory changes on insurers’ investment
strategies based on QIS5 technical specifications. The authors expect a shift to less
capital-intensive assets in the investment portfolios. Their survey shows that equities
remain a viable asset class under the new regime. For debt instruments, the authors
expect a shift into EEA sovereign debt and short-dated, high quality corporate debt to
reduce interest rate and credit spread risk capital requirements for larger duration
mismatches and corporate debt exposures. Regarding the importance of ratings, the
authors note that rating requirements could determine insurers’ investment strategies.
Several authors discuss the implications of Solvency II for insurance companies’
investment strategies either in general or in combination with the effects of the

7
Cheng and Weiss (2011).
8
Eling et al. (2008).
9
Schmeiser et al. (2006).
10
Eling et al. (2008, p. 431).
11
Rudschuck et al. (2010).
12
Van Bragt et al. (2010).
13
CGFS (2011).
 Dirk Höring
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253

implementation of the new Basel III regulation. All references are based on
preliminary documentation, that is the latest Basel III proposal and QIS5 technical
specifications. Jaffee and Walden14 investigate in a general equilibrium the effect of
a joint implementation of Basel III and Solvency II on the Swedish economy. They
conclude that the new regulations will have only a marginal long-term effect on
availability and cost of capital for Swedish households and firms. However, they share
concerns that Solvency II will impose heavy regulatory costs on insurance companies,
which will ultimately result in higher insurance premiums and lower demand for
insurance policies. Kaserer15 studies the implications of a joint reform of both banking
and insurance regulations on corporate financing. He states that insurance companies
will reduce their exposure to long-term corporate bonds especially with lower credit
quality in favour of EEA sovereign debt. He claims that the impact of the restructuring
of the insurance companies’ investment portfolios is large, since insurers are a
major institutional investor in Germany in both corporates and financials. This
could significantly increase financing costs for corporates and individuals, which may
result in economic slowdown. In an event study, Kaserer shows that the stock prices
of insurance companies decreased by 15 per cent on average in light of news of
Solvency II. Al-Darwish et al.16 discuss the consequences of a joint implementation of
Basel III and Solvency II. The authors conclude that since the Solvency II duration
multiplier penalises long-term maturities, insurance companies may opt to invest in
EEA sovereign debt, short-dated maturities or high-rated bank debt such as covered
bonds, which may reduce the ability of banks to issue longer-term unsecured debt.

Industry literature review

The joint report by Morgan Stanley and Oliver Wyman17 simulates the results of the
new Solvency II regulation based upon QIS5 specifications for four stereotype
insurance companies. Regarding the investment policies, the authors find a shift away
from equities and illiquid investments such as private equity into short-dated
corporate bonds. The authors also compare the QIS5 capital requirements for
premium and reserve risk with the capital requirements for a BBB rating from S&P.
Their analysis shows that rating capital is still the binding constraint for their non-life
insurers. Fitch18 simulates the impact of different investment strategies on the
regulatory capital requirements under Solvency II according to QIS5 specifications
showing their great influence. Moreover, the authors gather data on the return on
regulatory capital for credit risk for different asset classes showing that short-term
corporate bonds are an attractive investment. Deutsche Bank Research19 and the joint
work of the IIF and Oliver Wyman20 analyse the reciprocal effects between Basel III

14
Jaffee and Walden (2010).
15
Kaserer (2011).
16
Al-Darwish et al. (2011).
17
Morgan Stanley and Oliver Wyman (2010).
18
Fitch (2011).
19
Deutsche Bank Research (2011).
20
IIF and Oliver Wyman (2011).
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254

and Solvency II based on the latest Basel III proposal and QIS5 technical
specifications. Both studies argue that on the one hand, Solvency II favours short
maturities and good credit ratings as well as EEA sovereign debt and covered bonds.
On the other hand, Basel III requires banks to issue more stable, long-term sources of
funding. The authors of the Deutsche Bank Research report, however, do not expect
insurers to cease serving as investors in bank securities.

Insurance capital management

The objective of an insurance company should be the maximisation of its market
value. Insurance companies can maximise their market value by earning risk-adjusted
return on capital above the cost of capital, that is identifying profitable business lines,
products, customers or investment securities as well as exiting from unprofitable
ones.21 This search for excess yield is especially important in the current low-interest
environment in which insurance companies are struggling to meet guaranteed returns
and defined benefits and competition is increasing.22
Using the risk-adjusted return on capital requires an answer as to which definition
of capital should be used, that is what is the right denominator for this performance
measurement. Insurance companies have to manage different types of capital
simultaneously to satisfy the needs of all their stakeholders. For example, Swiss
Re23 states: We actively manage our capital to ensure that the Group and the Group
companies are adequately capitalised at all times. The level of capitalisation and the
capital structure are determined by regulatory capital requirements, rating agencies
requirements, as well as management’s view of risks and opportunities [internal capital
requirements].
Regulatory capital is an externally imposed minimum capital threshold required by
the regulating authorities in order to avoid regulatory intervention.24 Regulatory
capital frameworks include, for example, Solvency I, Solvency II, SST and U.S. Risk-
based Capital.25 Rating agencies such as A.M. Best and S&P evaluate the insurance
companies using multiple quantitative and qualitative criteria to assign credit ratings.
One of the criteria is the assessment of the capital adequacy of the insurance company
using risk-based capital models.26 Rating capital is an externally imposed capital
requirement to fulfil the capital adequacy criteria for a certain target rating. Finally,
insurance companies—especially large firms—have developed internal economic
capital management models for planning, pricing and managing their business.
Internal capital or economic capital is the capital required by management to ensure
continued operations even after extreme adverse events.27

21
See Cummins (2000).
22
See CGFS (2011, p. 32).
23
Swiss Re (2011, p. 35).
24
See Cummins (2000, p. 11).
25
See Eling and Holzmüller (2008) for an overview and comparison of risk-based capital standards.
26
See Hirschmann and Romeike (2004, p. 37).
27
See Deutsche Bank Research (2011, p. 9) and Swiss Re (2011, p. 36).
 Dirk Höring
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Insurance companies direct their capital management efforts towards the scarcest
resource, that is the most binding capital constraint.28 In the past, it seems as though
regulatory capital has not been a major constraint for most insurers under the
Solvency I regime.29 Furthermore, the CEIOPS30 and EIOPA31 impact studies reveal
that even the stricter Solvency II regulatory capital framework does not threaten
insurers’ regulatory capital adequacy.32 For example, QIS5 indicates that based upon
2009 data, 15 per cent of the participating insurance companies do not meet the
Solvency Capital Requirements (SCR) threshold and around 5 per cent do not meet
the lower Minimum Capital Requirement (MCR) threshold that may require
withdrawal of the operating authorisation.33 There is some anecdotal evidence to
suggest that rating or internal capital has been the relevant capital constraints in
the insurance industry in the past that have attracted capital management efforts.34
This paper analyses the question of whether the market risk charges under Solvency II
are a binding constraint for insurers, enforcing a restructuring of their investment
portfolios.

Methodology
This paper compares the market risk capital requirements for a representative
European-based life insurance company for the Solvency II standard model and
the S&P rating model.35 The Solvency II standard model is divided into six risk
modules including market, counterparty default, life underwriting, non-life under-
writing, health underwriting and intangible asset risk, each consisting of sub-modules.
The six risk modules are aggregated using correlations to calculate the Basic Solvency
Capital Requirement (BSCR). To arrive at the SCR, a capital charge for operational
risk is added and adjustments for the loss-absorbing capacity of technical provisions
and deferred taxes are incorporated.36 The market risk module is one of the most
important risk modules. Market risk makes up around 69 per cent of the BSCR for
solo insurance companies in Europe.37 The market risk module consists of seven sub-
modules, namely interest rate, equity, property, credit spread, currency, concentration
and illiquidity risk. The sub-modules are aggregated using correlations to account
for diversification effects arising between different market risks.38

28
See Morgan Stanley and Oliver Wyman (2010, p. 32) and SCOR (2011, p. 26).
29
See Doff (2007, p. 99).
30
CEIOPS (2008b).
31
EIOPA (2011).
32
See Jaffee and Walden (2010, p. 28), Barnier (2011, p. 2) and CGFS (2011, p. 31).
33
See EIOPA (2011, p. 25 and 27).
34
See Morgan Stanley and Oliver Wyman (2010, p. 3) and Fitch (2011, p. 12).
35
For Solvency II market risk regulatory capital requirements, the latest QIS5 calibrations and
specifications in CEIOPS (2010a) are used. For the rating capital requirements, the latest 2010 S&P
Insurance Capital Model Version 3 for Europe, the Middle East and Asia (EMEA) is used, sourced from
www.standardandpoors.com/ratings/insurance-capital-model/en/eu, accessed 25 January 2012.
36
See CGFS (2011, p. 29).
37
See EIOPA (2011, p. 63).
38
See EIOPA (2011, pp. 106–109).
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256

S&P uses its risk-based capital adequacy model as one building block for the
analysis of insurance companies’ capitalisation. The factor-based model provides
target risk-based capital requirements for the different rating levels, establishing
a specific degree of certainty. The levels of confidence are 97.2 per cent for “BBB”,
99.4 per cent for “A”, 99.7 per cent for “AA” and 99.9 per cent for “AAA”.39 Hence,
a target rating of “A” with a confidence level of 99.4 per cent coincides with the
Solvency II 99.5 per cent calibration.40 The rating model is divided into six risk
modules, namely investment, credit, other asset, life underwriting, non-life under-
writing and other liability risk, each consisting of sub-modules. The rating model
aggregates all risk modules considering only the diversification between life and non-
life risks. The investment risk module consists of five sub-modules: interest rate,
equity, property, credit spread and concentration risk. The sub-modules are
aggregated, accounting for diversification effects between the asset classes bonds,
equities and real estate. Furthermore, a size effect and analyst adjustments are
considered. The size effect incorporates the risk associated with smaller investment
portfolios.41
As a first step, the gross risk charges before diversification are compared to other
risk-reducing measures of the standard model and the rating model for different asset
classes for equity, credit spread and property risk. Interest rate risk is included in
the analysis in a further step. Table 1 shows an overview of the stress methodology
for the Solvency II standard model and the S&P rating model.
The risk sub-modules for currency, illiquidity and concentration risk are excluded
from the analysis due to their lesser importance.42 To compare the aggregated charges
for the market risk sub-modules equity, credit spread, property and interest rate risk in
a second step, I will use a representative European-based life insurance company’s
investment portfolio and balance sheet as a benchmark. In a final step, I will aggregate
the capital requirements for the single risk sub-modules to a total market risk capital
charge for the standard model and the rating model, thereby including the risk-
reducing effects of diversification within the market risk module between different
market risks. Also included are diversification effects between market risk and other
risks such as underwriting or counterparty credit risk, risk-absorbing capacity of
technical provisions and deferred taxes for the standard model, as well as
diversification between the asset classes and the size effect for the rating model.
Scenario analysis is conducted to substantiate the reliability of the results.

A representative European-based life insurer

The creation of the representative European-based life insurer’s balance sheet and
investment portfolio relies on several sources, including statistics from regulators,
insurance associations and rating agencies, as well as individual insurance companies’

39
See Standard & Poor’s (2010a, p. 4).
40
See CRO Forum (2011) for a discussion of economic and actual insolvency.
41
See the S&P Insurance Capital Model.
42
See EIOPA (2011, p. 72) for composition of market risk.
 Dirk Höring
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257

Table 1 Overview of Solvency II standard model and S&P rating model stress scenarios

Module Stress scenario Standard model capital charge S&P rating model capital charge
QIS5 (99.5%) A (99.4%)

Equity Sudden fall in the 30% for equities listed in EEA Depending on the geography
risk value of equities or OECD; 40% for other between 38–68% for equities
and alternative equities and alternative and 51–81% for private equity;
investments investments 48% for hedge funds

Property Sudden fall in the 25% for land, buildings, Depending on the geography
risk value of immovable property rights, between 11% and 24% for
properties participations in real estate third party use properties;
companies with periodic weighted average capital charge
income and property for owner-occupied properties,
investment for own use e.g. 20%

Credit Sudden fall in the Depending on rating and Depending on rating and time
spread value of bonds duration 0.9–60% for bonds; to maturity bucket 0.1–70% for
risk due to widening depending on maturity bonds; 0% for AAA-rated
credit spreads 0.6–32% for AAA-rated sovereign debt
covered bonds; 0% for EEA
sovereign bonds; depending on
rating and duration 0–45% for
non-EEA sovereign debt

Interest Change in net Net effect of upward and Capital charge on life bonds
rate risk value of assets downward shocks on swap depending on geography of
minus liabilities rates per maturity on value of insurance business 2–20%
due to a sudden interest rate sensitive assets and
fall or rise of liabilities, e.g. 1 year swap rate
interest rates +70%/ 75% and 10 year
swap rate +42%/ 31%

This table shows the stress scenarios and capital charges of the Solvency II standard model and the S&P
rating model for the market risk modules equity risk, property risk, credit spread risk and interest rate risk.

annual reports and investor presentations.43 The total economic balance sheet
composition of the representative life insurer is based upon the average market value
balance sheet of insurance companies according to QIS5 (Figure 1).44 Total assets and
the market risk portfolio of the life insurer are assumed to equal EUR 4.0 and 3.0
billion, respectively.45 On the asset side, a differentiation is made for assets relevant for

43
The sample consists of Allianz, AXA, Ageas, Aviva, Baloise, CNP Assurances, Fondaria SAI, Fortis,
Generali, Helvetia, Legal & General, Swiss Life, Vienna Insurance and Zurich.
44
See EIOPA (2011, pp. 36–39).
45
EUR 3.0 billion is approximately the average total investments of German life insurance companies in
2009. BaFin (2011, p. 7) reports the total number of German insurance companies excluding property
and casualty insurers and reinsurers as being 343 in 2009. Furthermore, in the BaFin (2011, p. 15)
statistics, the related investments equal EUR 977,507 million.
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258

Figure 1. Representative European-based life insurer’s economic balance sheet.

Note: This figure shows the economic balance sheet in per cent of the representative European-based life
insurer based upon the QIS5 results. The market risk portfolio on the asset side includes investments relevant
for the market risk modules such as equities and alternatives, real estate properties and debt instruments.
The credit risk portfolio contains assets relevant for the counterparty default risk modules such as
mortgages, policy loans, reinsurance assets and cash held at a bank. Other liabilities include for example
short-term debt and deferred tax liabilities.

the market risk modules (market risk portfolio), including equities and alternatives,
real estate properties and debt instruments. Separately, assets relevant for the
counterparty default risk modules (credit risk portfolio) include, for example,
mortgages, policy loans, reinsurance assets and cash held at a bank. The insurance
liabilities have a duration of 8.9 years, which is the median duration for life insur-
ance liabilities in Europe according to the results of QIS4.46 The duration mismatch
between assets and liabilities is 2.1 years. S&P assumes a duration mismatch of 1–10
years depending on the market and its structural features including the loss-absorbing
capacity of technical reserves.47 For the representative European-based life insurer, the
average European implied duration of 2 years is used for the rating model reflecting
markets such as Belgium, France, Italy, The Netherlands and Switzerland. The market
risk portfolio consists of equities and alternatives, real estate property and debt
instruments (Figure 2). The portfolio is invested relatively conservatively and follows
the congruence principle.
For equities, the standard model distinguishes between equities listed in the
regulated markets in countries that are members of the EEA or the OECD (global
equities) and other equities, which contain equities listed in emerging markets, non-
listed equities, private equity, hedge funds, and any other investments not covered
elsewhere in the market risk module.48 The rating model distinguishes equities

46
See CEIOPS (2008a, p. 182).
47
See Standard & Poor’s (2010a, pp. 31–32).
48
See CEIOPS (2010a, p. 113).
 Dirk Höring
Will Market Risk Requirements Bite?
259

Figure 2. Composition of market risk portfolio.

Note: This figure shows the composition of the market risk portfolio at market values in per cent of the
representative European-based life insurer based upon my sample of individual insurers’ annual reports and
investor presentations.

according to the country of their listing or, in the case of a well diversified equity
portfolio, according to the region of their listing.49 For the equity portfolio, let us
assume that the equity portfolio is sufficiently diversified to allow for the regional
rather than the country classification of the rating model. The regions specified by
S&P according to their equity volatility characteristics are Europe (Category 1), World
and Far East (Category 2), Emerging Far East and Latin America (Category 3),
Nordic and Arabia (Category 4), and the BRIC countries (Category 5).50 To compare
the standard model and the rating model, I assume that equities listed in the regional
categories Europe and World and Far East are equities listed in the OECD or EEA.
Finally, the rating model requires private equities to be allocated to a country or
region. Private equities are assumed to be domiciled in Europe (Category 1), which is
80 per cent of the equity portfolio (Figure 3).
While the standard model does not differentiate between different types of real
estate properties, the rating model categorises real estate properties as one’s own use or
owner-occupied properties and third party use properties. Real estate properties leased
or rented to third parties are classified into three regional categories. Category 1
contains Austria, Germany, The Netherlands, New Zealand and Switzerland.
Category 2 consists of Japan and other European countries. Category 3 includes

49
See Standard & Poor’s (2010a, p. 22).
50
Arabia is defined as the member countries of the Gulf Cooperation Council (GCC). The BRIC countries
include Brazil, Russia, India and China.
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260

Figure 3. Regional splits of equities, real estate properties and sovereign debt.
Note: This figure shows the regional composition of the equity portfolio, the real estate properties used by
third parties and the sovereign debt portfolio in per cent of the representative European-based life insurer
based upon my sample of individual insurers’ annual reports and investor presentations. The abbreviations
EM, BRIC and EEA shorten emerging markets, the countries Brazil, Russia, India and China, and the
European Economic Area.

Ireland, Spain, the United Kingdom, the United States and other countries not
included in any of the other categories. Similarly to the equity portfolio, the real
estate portfolio is invested prudently with high allocation to the more stable real estate
markets in categories 1 and 2 (Figure 3). Whereas the rating model relies only on
rating and time to maturity to calculate capital charges for sovereign debt, the
standard model distinguishes between sovereign debt issued by or guaranteed by
national governments of an EEA state in local currency and other sovereign debt.51
According to my sample of insurance companies, more than 80 per cent of a
representative sovereign debt portfolio is invested in the EEA (Figure 3).
The credit spread risk modules of both models require a combination of rating and
time to maturity or modified duration to determine the credit spread risk capital
charge.52 The majority of the fixed income instruments, with 96 per cent, is rated
investment grade, although the ratings of major European countries such as Greece
and Italy have suffered during the sovereign debt crisis.53 Table 2 shows an overview
of the rating distribution of the fixed income portfolio.
The credit spread risk module of the rating model requires a classification of bonds
according to their time to maturity into five times to maturity buckets. Table 3 shows
the distribution of time to maturities for the different fixed income asset classes.
Table 4 gives a comprehensive overview of the representative European-based life
insurer’s market risk investment portfolio.

51
See CEIOPS (2010a, p. 123).
52
See CEIOPS (2010a, p. 120).
53
See CGFS (2011, pp. 48–49).
Table 2 Rating of the fixed income portfolio

Asset class Allocation Rating distribution (per cent) Average

(per cent) rating
AAA AA A BBB BB B or lower Unrated

Sovereign debt (EEA) 39.0 58.8 20.6 18.1 0.6 1.9 — — AA

Sovereign debt (Non-EEA) 9.8 65.0 17.5 2.5 10.0 — 3.0 2.0 AA
Sovereign debt (Total) 48.8 60.0 20.0 15.0 2.5 1.5 0.6 0.4 AA
Corporate debt 36.0 17.5 15.0 40.0 20.0 2.0 0.5 5.0 A
Covered bonds 15.2 92.0 4.0 2.0 1.0 — — 1.0 AAA
Fixed income portfolio 100.0 49.6 15.8 22.0 8.6 1.5 0.5 2.1 AA

Note: This table shows the rating distribution of the fixed income portfolio. The table is based upon the sample of individual insurance companies’ annual reports
and investor presentations from 2009 and 2010. Asset class specifies the different asset classes in the fixed income portfolio of the representative insurer. Allocation
describes the percentage share of the asset class in the fixed income portfolio. AAA—Unrated states the percentage of each asset class within the specific rating
category. Average rating gives the weighted average rating of the asset class.

Table 3 Time to maturity and duration of the fixed income portfolio

Asset class Allocation (per cent) Time to maturity distribution (per cent) Duration (years)

o1 year 1–5 years 5–10 years 10–20 years >20 years

Will Market Risk Requirements Bite?

Sovereign debt 48.8 5.0 26.0 32.5 24.0 12.5 6.9
Corporate debt 36.0 13.8 27.9 35.1 23.3 — 5.4
Covered bonds 15.2 9.0 27.0 34.0 24.0 6.0 6.2
Fixed income portfolio 100.0 8.8 26.8 33.7 23.7 7.0 6.3

Note: This table shows the time to maturity distribution and the modified duration of the fixed income portfolio. The table is based upon the sample of individual
insurance companies’ annual reports and investor presentations from 2009 and 2010 and Market iBoxx EUR data. Asset Class specifies the different asset
classes in the fixed income portfolio of the representative insurer. Allocation describes the percentage share of the asset class in the fixed income portfolio.

Dirk Höring
The o1 year, y, >20 years-columns contain the percentage of each asset class within the specific time to maturity bucket. Duration gives the modified duration
in years of the asset class.

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Table 4 The representative European-based life insurer’s market risk portfolio

Standard model Rating model Rating Time to maturity (per cent) Total (per cent) Total (EUR m)

o1 year 1–5 years 5–10 years 10–20 years >20 years

Global equities Category 1a — — — — — — 4.0 120

Category 2b — — — — — — 0.5 15
Other equities Category 3c — — — — — — 0.2 6
Category 4d — — — — — — 0.1 3
Category 5e — — — — — — 0.2 6
Private Equityf — — — — — — 1.0 30
Hedge Funds — — — — — — 1.0 30
Equities total — — — — — — 7.0 210
Real estate Category 1g — — — — — — 6.5 195
Category 2h — — — — — — 3.0 90
Category 3i — — — — — — 0.5 15
Owner-Occupied — — — — — — 1.0 30
Real estate total — — — — — — 11.0 330

Sovereign debt Bonds AAA 0.9 4.9 6.1 4.5 2.4 18.8 564
(EEA) AA 0.3 1.7 2.1 1.6 0.8 6.6 198
Duration=6.9 A 0.3 1.5 1.9 1.4 0.7 5.8 174
BBB 0.0 0.1 0.1 0.0 0.0 0.2 6
BB 0.0 0.2 0.2 0.1 0.1 0.6 18
B or Lower — — — — — — —
Unrated — — — — — — —
Sovereign debt Bonds AAA 0.3 1.4 1.7 1.2 0.7 5.2 156
(Non-EEA) AA 0.1 0.4 0.5 0.3 0.2 1.4 42
Duration=6.9 A 0.0 0.1 0.1 0.0 0.0 0.2 6
BBB 0.0 0.2 0.3 0.2 0.1 0.8 24
BB — — — — — — —
B or Lower 0.0 0.1 0.1 0.1 0.0 0.2 7
Unrated 0.0 0.0 0.1 0.0 0.0 0.2 5
Sovereign debt total — 2.0 10.4 13.0 9.6 5.0 40.0 1,200
Corporate debt Bonds AAA 0.7 1.4 1.8 1.2 — 5.2 155
Duration=5.4 AA 0.6 1.2 1.6 1.0 — 4.4 133
A 1.6 3.3 4.1 2.7 — 11.8 354
BBB 0.8 1.6 2.1 1.4 — 5.9 177
BB 0.1 0.2 0.2 0.1 — 0.6 18
B or Lower 0.0 0.0 0.1 0.0 — 0.1 4
Unrated 0.2 0.4 0.5 0.3 — 1.5 44
Corporate debt total — 4.1 8.2 10.3 6.6 — 29.5 885

Covered bonds Bonds AAA 1.0 3.1 3.9 2.8 0.7 11.5 345
Duration=6.2 AA 0.0 0.1 0.2 0.1 0.0 0.5 15
A 0.0 0.1 0.1 0.1 0.0 0.3 8
BBB 0.0 0.0 0.0 0.0 0.0 0.1 4
BB — — — — — — —
B or Lower — — — — — — —
Unrated 0.0 0.0 0.0 0.0 0.0 0.1 4
Corporate debt total — 1.1 3.4 4.3 3.0 0.8 12.5 375
Fixed income portfolio total j — 7.2 22.0 27.6 19.5 5.8 82.0 2,460
Market risk portfolio total — — — — — — 100.0 3,000

Note: This table shows the composition of the market risk investment portfolio in per cent and EUR million. Standard Model covers the relevant asset classes for
the Solvency II standard model. Rating Model covers the relevant asset classes for the S&P rating model.
a
Equity Category 1 includes equities listed in Europe.
b
Equity Category 2 includes equities listed in World and Far East.
c
Equity Category 3 includes equities listed in Emerging Far East and Latin America.
d
Equity Category 4 includes equities listed in Nordic and Arabia.
e
Equity Category 5 includes equities listed in BRIC.

Will Market Risk Requirements Bite?

f
Private equities are domiciled in Europe.
g
Properties Category 1 includes properties in Austria, Germany, The Netherlands, New Zealand and Switzerland.
h
Properties Category 2 consists of Japan and other European countries.
i
Properties Category 3 includes Ireland, Spain, United Kingdom, United States and other countries.
j
Fixed Income Portfolio Total includes Sovereign Debt Total, Corporate Debt Total and Covered Bonds Total.

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Comparison of capital models

Gross risk capital charges
The analysis starts with a comparison of gross risk charges before diversification and
other risk-reducing effects for the equity risk, property risk and credit spread risk
modules for the Solvency II standard model and the S&P rating model.
On the one hand, comparing the gross equity risk charges, the rating model is more
restrictive than the standard model for all confidence levels above an A-rating or
a confidence level of 99.4 per cent. For example, whereas the standard model applies
a 40 per cent charge to hedge funds the rating model requires 47.5 per cent. On the
other hand, comparing the gross property risk charges, the standard model is generally
more restrictive than the rating model. The credit spread risk modules of the standard
model and the rating model apply to sovereign bonds, corporate bonds, covered bonds
and other fixed income securities.54 The standard model requires no gross capital
charge for sovereign debt issued in local currency in member states of the EEA and has
a special reduced gross capital charge for AAA-rated covered bonds.55 This practice
has been criticised due to the current development of the recent sovereign debt crisis.56
In contrast, the rating model only differentiates AAA-rated sovereign debt from other
corporate debt. Hence, the rating model is more restrictive than the standard model
for any target rating and confidence level for sovereign debt issued in local currency
in the EEA not rated AAA. For sovereign debt not issued in local currency in EEA
member states, the standard model applies specific risk charges.51 While the lowest
rating for the standard model is B, the rating model provides a specific risk charge for
ratings of CCC or lower. For unrated bonds, the rating model uses risk factors equal
to a BBB-rating, whereas the standard model is slightly less conservative and provides
risk factors in between a rating of BBB and BB. There is mixed evidence whether the
rating model or the standard model is more restrictive for credit spread risk charge for
non-EEA sovereign debt. For corporate debt, the comparison of gross credit spread
risk capital charges indicates that the standard model is more restrictive than the
rating model for corporate debt except for lower rating qualities. However, it should
be noted that this does not include the risk-reducing effects of diversification and the
loss absorption of technical provisions and deferred taxes, which significantly reduce
the risk capital charges, especially for the standard model.57 Moreover, the longer the
time to maturity or the modified duration and the lower the quality of the credit
rating, the higher is the risk capital charge for credit spread risk. For covered bonds,
the standard model applies a special lower credit spread risk charge in the case of an
AAA-rating. Still, the standard model remains more restrictive than the rating model
for covered bonds except for lower rating qualities.

54
See CEIOPS (2010a, pp. 119–120).
55
See CEIOPS (2010a, pp. 122–123).
56
Compare for example IIF and Oliver Wyman (2011, p. 12).
57
See Deutsche Bank Research (2011, p. 9) and Morgan Stanley and Oliver Wyman (2010, p. 3).
 Dirk Höring
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265

Capital charges for market risk sub-modules

Building on the analysis of gross risk capital charges, the aggregated charges are now
calculated for the risk sub-modules equity risk, credit spread risk, property risk and
interest rate risk for the representative European-based life insurance company’s
investment portfolio and balance sheet. The aggregation includes the intra equity risk
sub-module diversification effects between the asset classes global and other equity
described by the QIS5 technical specifications for Solvency II.58
To calculate the equity risk sub-module capital charge, the value of equities in the
specific equity asset classes is multiplied by the respective gross capital charge. For the
equity risk sub-module, the higher gross capital charges of the rating model translate
into a higher total capital charge for the equity risk sub-module even before
diversification effects within the equity risk sub-module, as specified by QIS5, are
considered. QIS5 accounts for the diversification effects between the equity asset
classes “Global Equity” and “Other Equity” using a correlation matrix, which
specifies a correlation coefficient of 0.75.58 Comparing the capital charges for the
equity risk sub-module, the rating model is more restrictive for any target rating above
BBB (97.2 per cent confidence level). For a comparable confidence level, that is a
target rating of A, the rating model requires 37 per cent more capital than the standard
model for equity risk (Table 5).
Likewise, the property risk sub-module capital charge is calculated by multiplying
the value of real estate properties in the specific real estate asset classes by the
respective capital charge. The higher gross capital charges for property risk of the
standard model translate into a higher total capital charge for the property risk
module. Comparing the capital charges for the property risk sub-module, the standard
model is always more restrictive. For a comparable confidence level, that is a target
rating of A, the standard model requires almost 86 per cent more capital than the
rating model for property risk (Table 5).
To calculate the credit spread risk sub-module capital charge according to the QIS5
specifications, the simplified approach was used.59 The simplified approach basically
allows one to use the weighted average modified duration for bond portfolios of equal
rating instead of a bottom-up calculation. The credit risk capital charge is calculated
as the product of the value of the bond portfolio with a specific rating times the
modified duration of the portfolio times the rating dependent risk factor. The rating
model stipulates a gross risk charge for each time to maturity bucket and rating
category, which is multiplied by the debt security’s value. For EEA sovereign debt, the
rating model is more restrictive, since only AAA-rated instruments are considered risk-
free. For non-EEA sovereign debt, corporate debt and covered bonds, the higher gross
capital charges for credit spread risk of the standard model translate into higher
capital charges. Comparing the total credit spread capital charges, the standard model
is always more restrictive than the rating model, that is the impact of EEA sovereign
debt is outweighed by the higher capital risk charges for corporate debt. For a

58
See CEIOPS (2010a, p. 114).
59
See CEIOPS (2010a, pp. 126–127).
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Table 5 Calculation of market risk capital requirements

Capital charges QIS5 AAA AA A BBB

(EUR million) (99.5%) (99.9%) (99.7%) (99.4%) (97.2%)

Global equities 40.5 64.2 57.5 51.9 36.9

Other equities 30.0 46.8 42.1 38.4 28.0
Gross equity risk 70.5 111.0 99.6 90.3 64.9
Equity diversificationa 4.4 — — — —
(a) Equity risk 66.1 111.0 99.6 90.3 64.9
(b) Property risk 82.5 59.4 52.3 44.4 31.5
Sovereign debt (EEA) — 9.2 8.6 8.1 7.1
Sovereign debt (Non-EEA) 6.0 5.2 5.0 4.7 4.2
Corporate debt 78.9 26.6 25.1 23.8 20.9
Covered bonds 15.7 4.0 3.7 3.4 2.9
(c) Credit spread risk 100.7 45.0 42.4 40.0 35.2
(d) Interest rate risk 112.2 120.5 107.0 97.9 74.0
S Gross market risk 361.4 335.9 301.3 272.6 205.6
Market risk diversificationb 64.3 27.0 24.1 21.6 15.9
Diversification haircutc — 13.5 12.1 10.8 8.0
Size effectd — — — — —
Market risk 297.2 322.4 289.3 261.8 197.7
Other diversificatione 53.2 — — — —
Loss-absorptionf 88.6 — — — —
Net market risk 155.4 322.4 289.3 261.8 197.7

Note: This table shows the calculation of capital charges for the market risk module of the standard model
and rating model in EUR million for the representative European-based life insurer with total assets of EUR
4.0 billion.
a
Equity diversification indicates the risk reduction due to the diversification effects between global equities
and other equities stipulated by the QIS5 technical specifications.
b
Market risk diversification provides the diversification credit between market risks for the standard model
and the rating model.
c
Diversification haircut is the regular 50 per cent haircut of the rating model’s diversification credit.
d
Size effect is a factor that decreases the effect of diversification of the rating model for smaller insurance
undertakings.
e
Other diversification is the diversification credit between market risk and other risks such as underwriting or
counterparty default risk allowed for by the rating model. The analysis assumes an average diversification
credit of 18 per cent on market risk.
f
Loss-absorption of technical provisions and deferred taxes is a risk-reducing effect allowed for by the
standard model. The analysis assumes an average reduction of 36 per cent on market risk after other
diversification effects.

comparable confidence level, that is a target rating of A, the standard model requires
152 per cent more capital than the rating model for credit spread risk (Table 5).
To calculate the capital charge for interest rate risk for the standard model, a
simplified approach was used. The QIS5 technical specification usually requires a
scenario-based approach, which specifies individual interest rate shocks per year
applied to interest rate-sensitive assets and liabilities.60 However, since I do not assume

60
See CEIOPS (2010a, pp. 110–111).
 Dirk Höring
Will Market Risk Requirements Bite?
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specific cash flow profiles for assets and liabilities, I approximated the interest rate
shock using a parallel shift of the swap rate curve multiplied by the duration mismatch
of assets and liabilities. Using the interest rates provided by BaFin and the QIS5
upward and downward interest rate shocks, the average parallel upward and
downward interest rate shocks are 1.3 and 1.3 percentage points (ppt), respectively.61
Since the representative European-based life insurer has a negative duration mismatch,
that is the duration of the liabilities exceeds the duration of the assets, only the
downward interest rate shock has a negative impact on the insurer’s own funds. The
interest rate capital charge for the standard model is calculated by multiplying the
downward interest rate shock of 1.3 per cent by the negative duration gap of 2.1
years and the market value of total assets of EUR 4.0 billion.62
The rating model stipulates a capital charge on bonds backing shareholders’ equity
and life liabilities depending on an implied mismatch between assets and liabilities
based upon the domicile of the life liabilities. In case assets cannot be segregated, the
lower-risk bonds are first allocated to life liabilities before they back shareholders’
equity.63 This is the approach used for my representative life insurer. Furthermore, I
assume that the liabilities are domiciled in European markets such as Belgium, France,
Italy, The Netherlands and Switzerland (Category 2), which have an implied duration
mismatch of 2 years according to the rating model. Furthermore, the life insurer
does not qualify to reduce the duration mismatch due to strong or excellent asset
and liability management risk controls. The rating model applies a capital charge
depending on the target rating of 4.9 per cent for AAA, 4.4 per cent for AA,
4.0 per cent for A and 3.0 per cent for BBB. Comparing the capital charges for the
interest rate risk sub-module, the standard model is more restrictive for any target
rating below AAA (99.9 per cent confidence level). For a comparable confidence
level, that is a target rating of A, the standard model requires 15 per cent more
capital than the rating model for interest rate risk (Table 5).

Capital charges for the market risk module

Comparing the sum of the capital charges for market risk sub-modules, the standard
model remains more restrictive than the rating model for all target ratings and
confidence intervals. For a comparable confidence level, that is a target rating of A,
the standard model requires 33 per cent more capital than the rating model for gross
market risk (Table 5). However, there are substantial risk-reducing effects allowed for
by the standard model that reverse the relationship of the standard model and the
rating model. The standard model specifies the risk-reducing effect of diversification
between different market risks by providing a correlation matrix that states, for

61
The BaFin interest rates are based upon swap rates as of December 2009 and a EUR liquidity premium
of 50 basis points. See CEIOPS (2010a, p. 111) for the interest rate shocks.
62
The duration gap of 2.1 years is calculated as the weighted average duration of the asset side minus the
weighted average duration of the liability side. The weighted average duration of the asset side is
calculated assuming a zero duration for equities, alternatives and properties for which no interest rate
shock applies.
63
See Standard & Poor’s (2010b, p. 12).
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268

example, a correlation coefficient of 0.75 between equity and real estate property risk
when a downward interest rate shock scenario is used.64 The rating model specifies a
correlation matrix in terms of asset classes including equities, real estate properties
and debt securities. Debt securities include the interest rate risk and the credit spread
risk arising from the asset class. For example, a correlation coefficient of 0.75 is
specified for equities and real estate properties. To account for the fact that risks do
not necessarily follow a multivariate normal or elliptical distribution—for example
due to tail risks or skewness—the standard model relies on tail correlations instead of
linear, conventional Pearson correlations to minimise the risk aggregation error.65
Given the uncertainties for example around tail correlations, S&P apply a 50 per cent
haircut to the diversification credit.66 If the insurers’ invested assets are below EUR
1.2 billion, a size factor is used to further reduce the diversification credit in the rating
model. The rating model’s diversification credit is thus significantly lower than the
standard model’s. Therefore, for a comparable confidence level, that is a target rating
of A, the standard model requires only 14 per cent more capital than the rating model
for market risk (Table 5). Furthermore, the standard model requires the calculation
of diversification credit between market risk and other risks, such as underwriting
risk and counterparty default risk.67 For example, the correlation coefficient between
market risk and counterparty default risk is 0.25.68 On the basis of the results of QIS5,
an average diversification credit of 18 per cent on market risk is used here. The rating
model allows no further diversification credit between market and other risks. Finally,
the standard model includes the risk-absorbing effect of technical provisions and
deferred taxes, which reduce the BSCR after diversification on average by 36 per
cent.37 This simple approach to allocate diversification credits and risk-absorbing
effects of technical provisions and deferred taxes implies an even distribution among
underlying risks. A more sophisticated allocation method tested on QIS5 data, which
takes into account the different levels of correlation between risks, shows no
substantially different results to the chosen approach in this paper.69 Including these
two risk-reducing effects, the rating model is now more restrictive than the standard
model for any target rating and confidence level. For a comparable confidence level,
that is a target rating of A, the rating model requires 68 per cent more capital for
net market risk than the standard model (Table 5). Hence, the rating model seems
to remain a binding capital constraint rather than the new regulatory capital require-
ments imposed by Solvency II (Figure 4).
On the basis of this case, I conducted sensitivity analysis to substantiate my previous
results. The sensitivity analysis changes the value of the asset classes equities,
properties, sovereign debt, corporate debt and covered bonds, as well as the corporate
debt portfolio’s average rating and modified duration ceteris paribus, that is the

64
See CEIOPS (2010a, p. 108).
65
See CEIOPS (2010b, pp. 337–338).
66
See Standard & Poor’s (2010a, p. 16).
67
See for example Hanewald et al. (2011) for an analysis of the correlation between mortality and market
risk.
68
See CEIOPS (2010a, p. 96).
69
See EIOPA (2011, pp. 31–32).
 Dirk Höring
Will Market Risk Requirements Bite?
269

Figure 4. Comparison of capital requirements for a representative EEA life insurer.

Note: This figure shows the capital charges in EUR million for the standard model according to QIS5
specifications and the rating model for a target rating of A. Net Diversification includes the diversification
credit between market risks and the 50 per cent diversification haircut for the rating model. Other
Adjustments contain the diversification credit between market and other risk and the loss absorbing effect of
technical provisions and deferred taxes according to the standard model.

composition of the remaining assets, rating distributions and maturity distributions

stay constant. The analysis shows the obtained result is, in principle, robust to
different asset compositions. The rating model requires 50–101 per cent more capital
than the standard model.

Conclusion
This paper investigates the question of whether the market risk capital requirements
outlined by the new risk-based regulatory framework Solvency II will significantly
impact the European insurance companies’ investment strategies. It analyses whether
these requirements are a binding constraint for insurers, enforcing a restructuring of
their investment portfolios and disrupting European capital markets. It compares the
market risk capital requirements of the Solvency II standard model with the S&P
rating model for a fictitious, but representative, European-based life insurer.
The comparison of the standard and the rating models’ gross charges indicate that
the rating model—calibrated to a target rating of A—is only more restrictive for the
asset classes equities and alternatives and EEA sovereign debt. However, the standard
model grants larger diversification credits between market risks and between market
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270

risks and underwriting risks, as well as a larger risk reduction due to the loss
absorbency of technical provisions and deferred taxes. Altogether, the rating model
requires 68 per cent more capital for market risk on a comparable confidence level
to the standard model, that is a target rating of A. However, even for a target rating
of BBB, that is a level of confidence of 97.2 per cent, the rating model requires
27 per cent more capital than the standard model. The sensitivity analysis shows that
this result is robust for a range of different asset compositions.
Hence, insurance companies, which defined a risk appetite above or equal to a
target rating of BBB, that is a confidence level of 97.2 per cent or an annual
probability of economic insolvency of 2.8 per cent, did and do not face a binding
regulatory capital constraint for market risk as defined by Solvency I or the Solvency
II standard model. Therefore, companies with a good credit rating and regulatory
solvency standing are not expected to significantly alter their asset allocations due
to the introduction of the risk-based regulatory requirements of Solvency II. Indeed,
surveys of European insurance companies indicate that a reduction in the heavily
penalised asset class of equities and alternatives is not expected.22 In this sense, a
recent survey on behalf of Black Rock, Inc. of 223 European insurers found that
allocations to alternative assets are expected to increase.70 Therefore, major
disruptions of European capital markets due to asset reallocations of European
insurance companies caused by Solvency II are not expected.71 Similar results are
expected for a typical property and casualty insurer’s investment portfolio. Although
such an investment portfolio is relatively small compared to a life insurer’s investment
portfolio, the share of equity investments tends to be larger and the share of debt
securities as well as the duration mismatch tend to be smaller.72 All of these differences
are more heavily penalised in the S&P rating model implying higher rating capital
requirements for market risk compared to the Solvency II standard model (Table 5).
There are several limitations inherent to the design of this study. Although the
balance sheet and investment portfolio of the representative European-based life
insurer is based upon the annual reports and investor presentations of a sample of
European insurance companies and the result is reinforced using sensitivity analysis,
the result is specific to the chosen example, which limits the general applicability of
the conclusions. Furthermore, the comparison of regulatory and rating capital is based
upon the implicit assumption that insurance companies hold exactly the capital
required. However, market pressure may force insurers to hold capital in excess of the
SCR. A back-of-the-envelope calculation based on the fictitious, but representative,
life insurance company’s investment portfolio and balance sheet shows that the insurer
could hold approximately 50 per cent in excess of Solvency II SCR requirements
before regulatory capital requirements exceed rating capital requirements calibrated
to a target rating of A. Furthermore, insurers may need either more or less than the
standard required capital to achieve their target rating due to analyst adjustments

70
See press clipping BlackRock study reveals significant challenges for insurers under Solvency II as of 13
February 2012. Sourced from www.ftseglobalmarkets.com, accessed 13 February 2012.
71
See Neville (2011) for comments on the current impact of Solvency II on debt capital markets.
72
See for example FINMA (2011, p. 9).
 Dirk Höring
Will Market Risk Requirements Bite?
271

within the rating process and due to the fact that the required rating capital is only
one of several components of the overall credit rating analysis.73 The calibrations for
the Solvency II standard model and the rating model are not finalised and will
potentially change over time.74 Moreover, European insurers will potentially adapt
partial or full internal models instead of the standard formula to calculate their
regulatory capital requirements. The impact of the use of internal models on the SCR
is still unclear and internal models have to be finalised by the insurance companies
and have to be approved by the regulator.75 The importance of ratings differs for
individual insurers. For example, reinsurance companies and property and casualty
insurers with strong commercial business lines depend on good credit ratings.76 The
importance of credit ratings overall changes over time, while the reputation of rating
agencies has suffered during the financial crisis.77 Finally, the analysis limits the
comparison of the standard model and the rating model to market risk capital require-
ments excluding capital requirements for other risks such as counterparty credit risk,
underwriting risk or operational risk, as well as available capital definitions. If
the rating capital model requires significantly less capital for other risks compared to the
standard model and/or is significantly less restrictive on the capital instruments allowed
to cover required capital, the relationship may reverse. However, there is some evidence
to suggest that the rating capital model is more restrictive in other building blocks of the
solvency calculation.78 Hence, interesting avenues for future research include the
extension of the comparison to other risks and include available capital as well as other
insurance lines such as property and casualty insurance and reinsurance companies.
Shortly before the going live of the Solvency II regulation there are still several
ongoing debates regarding the technical specifications and calibrations of the standard
model’s market risk module. For example, the zero credit spread risk capital charge
for EEA sovereign debt does not reflect the actual economic risk exposure of the
underlying asset, which is a key principle of the new regulatory framework. Further-
more, the zero credit spread risk capital charge creates an inconsistency between Pillar
1 and Pillar 2 of Solvency II as the own risk and solvency assessment process requires
recognition of such credit spread risk. Finally, the zero credit risk capital charge
provides disincentives to develop an internal model for EEA sovereign debt, which
would need to consider the credit spread risk of EEA sovereign debt to pass the Pillar 2
use test. Another heavily discussed topic is the Solvency II calibration including size of
the shocks and correlations.79 In particular, my analysis indicates that diversification
credit granted by the standard models seems relatively high compared to the S&P
rating model.

73
See Standard & Poor’s (2010a, p. 5).
74
See CGFS (2011, p. 37), Deutsche Bank Research (2011, p. 10).
75
See CGFS (2011, p. 37).
76
See Morgan Stanley and Oliver Wyman (2010, p. 38).
77
See CGFS (2011, p. 38).
78
See Morgan Stanley and Oliver Wyman (2010). Moreover, it seems like Standard & Poor’s (2010a, p. 9)
is more restrictive with regard to their definition of available capital that for example considers only 50
per cent of the value-in-force.
79
See Mittnik (2011).
The Geneva Papers on Risk and Insurance—Issues and Practice
272

The ongoing sovereign debt crisis has a severe impact on the European life insurance
industry. The greatest threats for European life insurers are linked to their significant
holdings of distressed European sovereign and banking debt as well as their exposure
to a worsening macroeconomic environment including deteriorating equity prices and
falling interest rates. The sensitivity analysis on this paper’s result indicates that
worsening sovereign and corporate debt ratings and changes in portfolio allocation
have no impact on the paper’s conclusion: the Solvency II standard model remains less
capital-intensive than the S&P rating model for comparable levels of confidence.
However, impairments on distressed European sovereign and banking debt further
deteriorate insurers’ available capital base, and have already caused several rating
downgrades in the European insurance industry. Hence, as a response to the sovereign
debt crisis some life insurers may be forced to further derisk their underwritings and
investments to protect their ratings as well as their economic and regulatory solvency.

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About the Author

Dirk Höring studied business administration at the Humboldt University of Berlin and
the University of Virginia. Between 2007 and 2009 he worked for the Risk
Management Practice of McKinsey & Company, Inc. In 2009 he started his doctoral
studies at the Dr. Wolfgang Schieren Chair of Insurance and Risk Management at the
Humboldt University of Berlin. His research interests include risk disclosures,
organisation of risk management and insurance regulation.