Effects of Solvency II on Asset Allocation

The current structural low-interest environment is encouraging institutional investors to rethink their asset allocation strategies and increase their exposure towards alternative asset classes, such as real estate and infrastructure. This is particularly the case for insurance companies, which come under pressure to reduce their investment in currently low-yielding government bonds, given the high interest rate guarantees associated with obligations from existing life insurance contracts. As a consequence, insurance companies may be forced to rearrange their assets appropriately. However, the forthcoming Solvency II Directive could counteract this scenario. After Solvency II comes into effect, insurance companies will be subject to higher capital requirements aimed at ensuring insurance-protection even in the case of macroeconomic shocks. The Solvency Capital Requirements (SCR) varies by asset class and is determined by the Solvency II standard formula, which also determines the methodology used to aggregate the respective required equity position. Therefore, it may become necessary for insurers to minimize the SCR by means of their asset allocation, depending on their capitalization, profitability and the general competitive dynamics. If the results of such an optimization are not in accordance with those of conventional optimal asset allocation, Solvency II will lead to inefficient capital allocation in practice. As a result, the portfolio risk would increase, which contradicts the original purpose of the regulation. Furthermore, changing investment behavior from insurers might also have direct effects on the pricing and the product range offered on the capital markets, e.g. for real estate investments.We therefore analyze, whether the Solvency II standard formula could indeed cause the abovementioned incentive incompatibility with respect to the asset allocation process. The main focus lies on the potential shift of direct real estate and direct infrastructure weights within the portfolios of insurers under the Solvency II regime.