The Impact of Private Equity on a Life Insurer's Capital Charges Under Solvency II and the Swiss Solvency Test

Abstract

In this article, we conduct an in-depth analysis of the impact of private equity investments on the capital requirements faced by a representative life insurance company under Solvency II as well as the Swiss Solvency Test. Our discussion begins with an empirical performance measurement of the asset class over the period from 2001 to 2010, suggesting that limited partnership private equity funds may be suited for the purpose of portfolio enhancement. Subsequently, we review the market risk standard approaches set out by both regulatory regimes and outline a potential framework for an internal model. Based on an implementation of these solvency models, it is possible to demonstrate that private equity is overly penalized by the standard approaches. Hence, life insurers aiming to exploit the asset class's return potential may expect significantly lower capital charges when applying an economically sound internal model. Finally, we show that, from a regulatory capital perspective, it can even be less costly to increase the exposure to private rather than public equity. and caroline.siegel@unisg.ch, respectively. We are grateful to two anonymous referees as well as Karin Jans, Andy Hawson, and Joerg Allenspach of Swiss Re for their helpful comments and suggestions.

Basel Accords versus Solvency II - Regulatory Adequacy and Consistency Under the Postcrisis Capital Standards

“…Thus the models cannot take risk dependencies into account -a proceeding that is in sharp contrast to the empirical evidence (see, e.g., Braun et al, 2013). Furthermore, due to the lack of dynamic risk magnitudes, the resulting capital charges might become inadequate over time.…”

“…As the weights of all securities must sum up to 100%, an increase of the portfolio weight of one asset class must be accompanied by a reduction in the portfolio weights of other asset categories. These "residual portfolio weights" are calculated such that the relative weights between pairs of asset classes remain the same (this method was introduced by Braun et al, 2011, and applied by Braun et al, 2013). For example, if the percentage of stocks is raised, the weight of cash at bank is reduced such that it remains twice the weight assigned to alternative investments.…”

“…Norming the joint distribution function of risk factors to zero implies, however, that the individual risk-return profiles of asset classes are no longer identifiable. Thus, the sole focus on volatility inadequately promotes low risk asset classes (see also Braun et al, 2013), and may lead to severe biases in the investment incentive scheme. Nevertheless, depending on the concrete parameter specification, this is the most promising standardized capital adequacy model for the European banking system, so far.…”

“…Moreover, regarding the model calibration,the applied historical index data exhibits very different values at risk. Nevertheless, the formula still subsumes several asset classes under the same stress factor (see also Braun et al, 2013). As an example, the stress applied to "other equities" of -42% comprises all alternative investments, including private equity, hedge funds, commodities, and others, although the empirically deduced stress varies between -23% and -69%.…”

Calculation of Solvency Capital Requirements for Non-life Underwriting Risk Using Generalized Linear Models

“…Some of them examine credit or equity risk, for example, Santomil et al (2011), Gatzert and Martin (2012), Braun, Schmeiser, and Siegel (2014), or analyse the specific risks within the life underwriting risk (catastrophic or longevity risk), for example Kraut and Richter (2015). The unique study of SCR for non-life underwriting risk is the work of Jonas Alm, Alm (2015), who compares SCR generated by simulation model with different distributional assumptions with the standard formula.…”