An investigation of the Volatility Adjustment

Abstract

We use market data to reconstruct the volatility adjustment, a component of the Solvency II framework designed to mitigate the impact of market risk on insurance liabilities, of different countries on a monthly basis. Only partially in agreement with the regulation, we observe that the volatility adjustment, especially the proposed new mechanism, is not affected by credit quality, illiquidity of bonds, and investors’ risk appetite, but by turbulence in financial markets and equity market performance. We also show that the new mechanism proposed by EIOPA performs differently with respect to the one in force at the time of writing the current paper, yielding higher and smoother values and providing a relief to insurance companies on the Solvency II capital requirement front.