Solvency II's Market Risk Standard Formula: How Credible Is the Proclaimed Ruin Probability

Alexander Braun, Hato Schmeiser and Florian Schreiber

Journal of Insurance Issues, 2015, vol. 38, issue 1, 1-30

Abstract: We assess the credibility of the ruin probability allegedly associated with themarket risk standard formula of Solvency II, the new regulatory framework for theEuropean insurance industry. For this purpose, we draw on the empirical risk-returnprofiles of six major asset classes and derive mean-variance efficient portfolio compo-sitions, taking into account both short-sale constraints and the prevailing legal invest-ment limits in Germany. In a next step, the capital requirements under the standardformula are calculated for each asset allocation. Employing the respective results, wethen invert an internal model for market risk based on full statistical distributionsinstead of mere stress factors to estimate the actual ruin probabilities correspondingto the efficient portfolios. In most cases, the latter deviate substantially from theproclaimed target of the regulator. Since a large fraction of small to medium-sizedcompanies is likely to resort to the standard formula, the introduction of Solvency IIcould lead to a lot more ambiguity about insolvency risk in the European insurancesector than currently expected.

Date: 2015
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