Portfolio Optimization Under Solvency II: Implicit Constraints Imposed by the Market Risk Standard Formula

31 Pages Posted: 6 Feb 2017

See all articles by Alexander Braun

Alexander Braun

University of St. Gallen - I.VW-HSG

Hato Schmeiser

University of Muenster - Faculty of Economics; University of St. Gallen - I.VW-HSG

Florian Schreiber

University of St. Gallen - I.VW-HSG

Date Written: March 2017

Abstract

We optimize a life insurance company's asset allocation in the context of classical portfolio theory when the firm needs to adhere to the market risk capital requirements of Solvency II. The discussion starts with a brief review of the standard formula and the introduction of a parsimonious partial internal model. Subsequently, we estimate empirical risk–return profiles for the main asset classes held by European insurers and run a quadratic optimization program to derive nondominated frontiers with budget, short‐sale, and investment constraints. We then compute the capital charges under both solvency models and identify those efficient portfolio compositions that are permitted for an exogenously given amount of equity. Finally, we consider a systematically selected set of inefficient portfolios and check their admissibility, too. Our results show that the standard formula suffers from severe shortcomings that interfere with economically sensible asset management decisions. Therefore, the introduction of Solvency II in its current form is likely to have an adverse impact on certain parts of the European insurance sector.

Suggested Citation

Braun, Alexander and Schmeiser, Hato and Schreiber, Florian, Portfolio Optimization Under Solvency II: Implicit Constraints Imposed by the Market Risk Standard Formula (March 2017). Journal of Risk and Insurance, Vol. 84, Issue 1, pp. 177-207, 2017. Available at SSRN: https://ssrn.com/abstract=2911347 or http://dx.doi.org/10.1111/jori.12077

Alexander Braun (Contact Author)

University of St. Gallen - I.VW-HSG ( email )

Kirchlistrasse 2
St. Gallen, 9010
Switzerland

Hato Schmeiser

University of Muenster - Faculty of Economics ( email )

Universitätsstr. 14-16
48143 Munster
Germany

University of St. Gallen - I.VW-HSG ( email )

Kirchlistrasse 2
St. Gallen, 9010
Switzerland

Florian Schreiber

University of St. Gallen - I.VW-HSG ( email )

Tannenstrasse 19
St. Gallen, 9010
Switzerland

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