Asset Concentration Risk and Insurance Solvency Regulation

Historical evidence shows that asset concentration risk in terms of name and sector concentration plays an important role for the stability of financial institutions. Due to their large asset portfolios, insurance companies seem to be particularly exposed to this risk type. For example, AIG’s assets had a real estate sector exposure of 25% during the financial crisis 2007-09 (McDonald and Paulson (2015)), and even today insurers still accumulate high sector exposures. German insurers have roughly 27% of their total assets exposed to the German financial sector (IMF (2018)) which, in case of a large shock, could cause severe consequences.

However, there is a lack of literature regarding asset concentration risk. It has been primarily discussed in the context of banks’ loan activities (Düllmann and Masschelein (2007)) but has been neglected with regard to the asset side of insurers. Moreover, regulatory frameworks like Solvency II and the Global Insurance Capital Standards (ICS) even entirely exclude sector concentration risk from the calculation of capital requirements (European Union (2015)).

Since the inadequate regulatory treatment of asset concentration risk can lead to insufficient solvency capital levels, we are the first to evaluate the current regulatory approaches under various frameworks (Solvency II, the NAIC's RBC framework, the ICS and Basel III). We also disclose potentially adverse incentive effects and critically discuss the underlying assumptions. The basis for our analysis is a stylized theoretical portfolio model by which we quantitatively study the solvency capital allocation for asset concentration risk. Thereby, we decompose the return of an asset in an idiosyncratic (name-specific) and a systematic (sector-specific) risk component and determine the solvency capital requirements based on a Value at Risk (VaR) approach as well as on Solvency II's and ICS’s standard formulas.

Our preliminary results suggest that neglecting sector concentration risk is not justified and causes imprecise capital requirements. Moreover, the idiosyncratic and systematic risk exposures of a portfolio interact and influence the solvency capital requirements substantially. Finally, due to the missing link between asset concentration and the insurer’s risk profile, our project is intended to serve as a basis for future empirical investigations, e.g. on procyclical investment behavior, which can be a major source for systemic risk in the insurance sector.