Basel III and Solvency II - Risks and Side-Effects from their Interplay

Project Start: 04/2013
Status: Completed
Researchers: Helmut Gründl
Category: Financial Institutions, Systemic Risk Lab
Funded by: LOEWE

Topic and Objectives

The global financial crisis continues to shape European life insurers' business performance. A lingering uncertain economic environment, prolonged low interest rates and a changing regulatory framework pressure the stability of the industry. Especially the current low interest rate environment poses a key risk for life insurance companies since declining returns on investments jeopardize the guaranteed return on life insurance contracts. To be able to fulfill guaranteed returns to policyholders, life insurers will have to adjust their asset allocation.

SAFE Working Paper No. 97 assesses how Basel III, Solvency II and the low interest rate environment will affect the financial connection between the bank and insurance sector. It considers a contingent claim framework with a direct financial connection between banks and life insurers via bank bonds. Given the scale and importance of insurers' investments into bank bonds, any shift in their asset allocation caused by economic conditions or new financial regulation could have a distorting effect on the connectedness of the banking and insurance sector.

SAFE Working Paper No. 98 looks into the effects of contingent convertible (CoCo) bonds, as recommended by the Liikanen Group, for the capital requirements of insurance companies under the upcoming Solvency II standards. CoCo bonds are a form of long-term debt with a fixed coupon rate that automatically convert to equity when a predetermined trigger is met. In the current low interest rate environment, CoCo bonds are of increasing interest for life insurers that are in search of higher yielding fixed-income securities. To assess the effect of CoCo bonds on insurers' capital requirements, besides using the Solvency II standard model, we develop an internal model that anticipates possible future conversions, i.e. bank share holdings.

Key Findings

SAFE Working Paper No. 97

  • Life insurers' portfolio composition will change significantly over the mid-term since they engage in more risky investments, especially bank bonds. Particularly, when the gap between the return on assets and the average guaranteed return on policyholder's accounts becomes smaller, life insurers' appetite for risk increases.
  • Life insurers need to increase the amount of equity capital to cope with the given economic conditions as well as the change in their asset allocation.
  • The contagion risk between bank and life insurer is driven by the insurers' demand for bank bonds which itself depends on the regulatory safety Ievel of banks.

SAFE Working Paper No. 98

  • There are large differences in the capital charges for insurers under the Solvency II standard model and our internal model. Since the current standardized assessment of market risk depends on relatively crude risk weights, it is not able to reflect the entire risk profile of a CoCo bond. Thus, it can mislead CoCo investors and does produce economically irrational incentives.
  • According to the internal model capital requirements for CoCo bonds increase with increasing trigger value, decreasing conversion ratio as well as increasing bank risk.
  • CoCo bonds Iead to higher capitaI charges than non-convertible bonds if bank risk is low, and to lower capital requirements if bank risk is high.
  • For high bank risk, insurers clearly benefit from buying CoCos due to lower capital charges and a higher coupon rate.

Policy Implications

SAFE WP No. 97 shows that in its current form, Basel III and Solvency II could reduce the strength of the financial connection between banks and insurance companies in the long-run. Against this background, we strongly encourage regulators and policy makers to integrate banking and insurance regulation to minimize unintended effects. As a first step, we recommend policy makers to establish a closer communication among banking and insurance regulators.

SAFE WP No. 98 reveals that the current set-up and calibration of the Solvency II standard formula for market risk are inadequate with respect to the treatment of CoCo bonds. By highlighting substantial weaknesses of the market risk module, we hope that our results provide an additional impulse for improving it.

Related Published Papers

Author/s Title Year Research Area Keywords
Helmut Gründl, Tobias Niedrig The Effects of Contingent Convertible (CoCo) Bonds on Insurers’ Capital Requirements under Solvency II
The Geneva Papers on Risk and Insurance: Issues and Practice
2015 Financial Institutions, Systemic Risk Lab Contingent Convertible Capital, CoCo Bond, Basel III, Solvency II, Life Insurance, Interconnectedness
Tobias Niedrig Optimal Asset Allocation for Interconnected Life Insurers in the Low Interest Rate Environment Under Solvency Regulation
Journal of Insurance Issues
2015 Financial Institutions, Systemic Risk Lab Basel III, Solvency II, Life Insurance, Interest Rate Guarantees, Asset Allocation, Contagion, Interconnectedness

Related Working Papers

No. Author/s Title Year Research Area Keywords
97 Tobias Niedrig Optimal Asset Allocation for Interconnected Life Insurers in the Low Interest Rate Environment Under Solvency Regulation 2015 Financial Institutions, Systemic Risk Lab Basel III, Solvency II, Life Insurance, Interest Rate Guarantees, Asset Allocation, Contagion, Interconnectedness
98 Helmut Gründl, Tobias Niedrig The Effects of Contingent Convertible (CoCo) Bonds on Insurers’ Capital Requirements under Solvency II 2015 Financial Institutions, Systemic Risk Lab Contingent Convertible Capital, CoCo Bond, Basel III, Solvency II, Life Insurance, Interconnectedness

 

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