Optimal asset allocation for interconnected life insurers in the low interest rate environment under solvency regulation

Tobias Niedrig

No 97, SAFE Working Paper Series from Leibniz Institute for Financial Research SAFE

Abstract: I assess how Basel III, Solvency II and the low interest rate environment will affect the financial connection between the bank and insurance sector by changing the funding patterns of banks as well as the investment strategies of life insurance companies. Especially for life insurance companies, the current low interest rate environment poses a key risk since declining returns on investments jeopardize the guaranteed return on life insurance contracts, a core component of traditional life insurance contracts in several European countries. I consider a contingent claim framework with a direct financial connection between banks and life insurers via bank bonds. The results indicate that life insurers' demand for bank bonds increases over the mid-term but ultimately declines in the long-run. Since life insurers are the largest purchasers of bank bonds in Europe, banks could lose one of their main funding sources. In addition, I show that shareholder value driven life insurers' appetite for risk increases when the gap between asset return and liability growth diminishes. To check the robustness of the findings, I calibrate a prolonged low interest rate scenario. The results show that the insurer's risk appetite is even higher when interest rates remain persistently low. A sensitivity analysis regarding industry-specific regulatory safety levels reveals that contagion between bank and life insurer is driven by the insurers' demand for bank bonds which itself depends on the regulatory safety level of banks.

Keywords: Basel III; Solvency II; Life Insurance; Interest Rate Guarantees; Asset Allocation; Contagion; Interconnectedness (search for similar items in EconPapers)
JEL-codes: G11 G18 G22 G28 (search for similar items in EconPapers)
Date: 2015
New Economics Papers: this item is included in nep-ban and nep-ias
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:safewp:97

DOI: 10.2139/ssrn.2593032

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