We investigate the impact of the upcoming Solvency II guidelines on the risk/return tradeoff for life insurance companies. Using the Dutch (FTK) regulatory framework (Financieel ToetsingsKader or Financial Assessment Framework) as an example, we demonstrate the huge impact of the elements of Solvency II (balance sheet approach, market valuation, etc.) on capital requirements. Much attention is also paid to the impact of the investment policy on the required capital. It is shown that by reducing the short-term risk (as measured by the required capital) the long-term expected returns may also decrease. Insurers should therefore (still) perform additional multi-period calculations for different stochastic scenarios in order to truly optimize their risk/return trade-off.

Liability-driven investing (LDI) has recently emerged as a powerful paradigm in financial risk management. The basic idea behind LDI is to split the company's balance sheet into two separate balance sheets: one for the liabilities and the matching assets and one for the other (return) assets and the surplus. We show that constructing a proper liability-hedging portfolio (LHP) is very attractive for life insurers because the liability-driven risks can be suppressed without a negative impact on overall return. When these risks are covered by the LHP, the return assets can be optimised using well-known (Markowitz) optimisation techniques or (equity) hedge strategies. The LDI approach thus stimulates insurers to address all risks embedded in the insurance liabilities and facilitates the subsequent optimisation of the return assets.

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