Basis Risk, Procylicality, and Systemic Risk in the Solvency II Equity Risk Module

Martin Eling and David Pankoke

No 1306, Working Papers on Finance from University of St. Gallen, School of Finance

Abstract: This paper analyzes the equity risk module of Solvency II, the new regulatory framework in the European Union. The equity risk module contains a symmetric adjustment mechanism called equity dampener which shall reduce procyclicality of capital requirements and thus systemic risk in the insurance sector. We critically review the equity risk module in three steps: we first analyze the sensitivities of the equity risk module with respect to the underlying technical basis, then work out potential basis risk (i.e., deviations of the insurers actual equity risk from the Solvency II equity risk), and — based on these results — measure the impact of the symmetric adjustment mechanism on the goals of Solvency II. The equity risk module is backward looking in nature and a substantial basis risk exists if realistic equity portfolios of insurers are considered. Both results underline the importance of the own risk and solvency assessment (ORSA) under Solvency II. Moreover, we show that the equity dampener leads to substantial deviations from the proposed 99.5% confidence level and thereby reduces procyclicality of capital requirements. Our results are helpful for academics interested in regulation and risk management as well as for practitioners and regulators working on the implementation of such models.

Keywords: Solvency II; procyclicality; systemic risk; CoVaR; MES. (search for similar items in EconPapers)
JEL-codes: G22 G28 G32 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2013-02
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
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Citations: View citations in EconPapers (10)

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Persistent link: https://EconPapers.repec.org/RePEc:usg:sfwpfi:2013:06

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