Introducing the EDHEC-Risk Solvency Benchmarks – Maximising the Benefits of Equity Investments for Insurance Companies facing Solvency II Constraints

The Solvency II Directive introduces a prudential framework for the computation of regulatory capital requirements for insurers. It specifically defines a standard formula that must be applied by default and serves as a reference point for more advanced approaches, notably partial or full-blown internal models. Solvency II regulators have detailed the design, construction, calibration and implementation of this standard formula. For the insurance sector, the capital requirement associated with equity investments remains prohibitive. Some large insurance companies have already reacted by starting to reduce their exposure to equity risk. This is not just the result of the recent market downturns, but also in preparation for the new regulatory constraints. Other firms are likely to follow suit and make a clear move away from equity in the near future.

This forced shift from equity is not good news for the industry. The basis for sound investment should be proper diversification and risk management, without shying away from capturing the equity risk premium altogether. The stringency of the standard formula will be particularly prejudicial to firms that do not have the resources to develop an internal risk model that would make equity investment less costly.

In order to alleviate this issue, EDHEC-Risk Institute is introducing a framework for designing dedicated dynamic asset allocation solutions, as part of a research chair supported by Russell Investments. These Solvency II dynamic allocation benchmarks, or Solvency II benchmarks in short, should be regarded as substitutes for static equity investments by insurance companies. They can be used by insurance companies to achieve a substantial exposure to equity risk and the associated premium, while maintaining strict and explicit control over the implied Solvency II charge.

The conceptual foundation for this approach relies upon two main paradigms known as life-cycle investing (LCI) and risk-controlled investing (RCI) respectively. Thanks to these two components, it meets the challenge of reconciling long-term performance objectives and short-term solvency constraints. After recapping the relevant items from Solvency II, this paper introduces the theoretical foundation and the implementation of this proposed solution.