Why Life Insurers Have Equity Risk Through Investments and Products
Summary
The document explains that life insurers can face equity risk through both their investment portfolios and the products they sell. In the European Union, Solvency II does not impose a blanket ban on equity holdings. Instead, insurers must hold sufficient own funds to withstand a severe stress, and the regulatory capital requirement reflects the risks associated with their assets. The answer distinguishes eligible own funds from other funds and notes that the rules governing capital eligibility and equity charges are detailed.
Product design can also create exposure. Variable annuities may promise guarantees linked to equity funds, leaving the insurer exposed to market losses. Unit-linked policies without guarantees can still affect an insurer’s earnings because fees often depend on assets under management; falling equity markets can shrink those assets and reduce fee income. The regulatory discussion is framed around the European insurance industry, and the document does not quantify exposures or compare rules in other jurisdictions. It shows why equity risk can arise even when liabilities and some supporting assets are conservative.
Key ideas
- European Solvency II rules permit insurers to hold equities and account for their risk in capital requirements.
- Insurers must maintain eligible own funds to meet regulatory solvency requirements under stress.
- Variable annuity guarantees linked to equity funds can expose insurers to market losses.
- Unit-linked products can reduce fee income when falling markets shrink assets under management.
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Full text
# Why do (life) insurance companies face equity risk? # Why do (life) insurance companies face equity risk? I am currently reading through a study published by the Institute and Faculty of Actuaries on hedging practices within the insurance industry. Within the executive summary, under 'Key Risks', it is stated that > Equity, credit and interest rates are the big three dominant risks out of our respondents My question is, why might an insurance company be exposed to equity risk? Insurers are only allowed to back their liabilities with very safe assets (i.e. gilts and high quality corporate bonds) so, if I'm right in thinking that equity risk is the risk of loss from holding stocks, why would an insurance company have exposure to this? ## Answer by Bob Jansen (score 4, accepted) https://quant.stackexchange.com/a/54712 The publication is made by the UK institute of actuaries so I'm answering from the perspective of the insurance industry in the European union. ### Is it allowed? For European Insurance companies EIOPA gathers a number of statistics, among which asset exposures. The table below shows figures as of 2019Q4: So, at least for insurance companies that are supervised by EIOPA and related supervisors, it's not true they are not allowed to hold equities. ### Rules under Solvency II European insurance companies are supervised under the Solvency II framework. Under this framework insurance companies need to ensure that they have enough capital to withstand once in 200 year shock using their own funds (basically 99.5% VaR), this is the Solvency Capital Requirement (SCR). The Dutch supervisor DNB defines basic own fund as > Basic own funds The basic own funds consist of (i) the excess of assets over liabilities, and (ii) subordinated liabilities. ... > Eligible own funds The classification into tiers is relevant to the determination of eligible own funds. These are the own funds that are eligible for covering the regulatory capital requirements – the solvency capital requirement and the minimum capital requirement. For example, the minimum capital requirement must be covered by Tier 1 and Tier 2 capital and may not therefore be covered by Tier 3 capital. The extent to which the tiers are eligible to cover the capital requirements is set out in the implementing measures (also known as delegated acts). Not all own funds are eligible to cover the loss under the shock, eligible own funds made of high quality assets such as government bonds. The rest of the funds are under less strict rules. The Solvency II framework gives a detailed prescription of what funds must be held and how much risk stems for equity holdings and this impact the SCR calculation. The rules are quite detailed and far from a complete ban on equity holdings. ## Answer by g g (score 1) https://quant.stackexchange.com/a/54713 In addition to regulatory considerations for investments, the presence or absence of equity risk depends on the products sold. Two products which expose life companies to substantial equity risk are Variable Annuities or even just standard Unit Linked policies. Variable Annuities provide guarantees on equity funds. So they obviously create equity risk. But even for general Unit Linked products without guarantees you run a risk since your profits are (to a large extent) fees for assets under management. So if your assets shrink, your profits will shrink as well.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.