Basis Risk, Procyclicality, and Systemic Risk in the Solvency II Equity Risk Module

The purpose of this paper is to systematically analyze the equity risk module of Solvency II, the new regulatory framework in the European Union. The particularly interesting aspect of this module is that it contains a symmetric adjustment mechanism commonly known as equity dampener which shall reduce procyclicality and thus systemic risk in the insurance industry. We critically review the equity risk module in three steps: we first analyze the sensitivities of the equity risk module with respect to the underlying technical basis, then work out potential basis risk (i.e., deviations of the insurers actual equity risk from the Solvency II equity risk), and—based on these results—measure the impact of the symmetric adjustment mechanism on the goals of Solvency II. The equity risk module is backward looking in nature and a substantial basis risk exists if realistic equity portfolios are considered. Also, the adjusted capital stress substantially deviates from the proposed 99.5% confidence level. Our results are helpful for academics interested in regulation and risk management as well as for practitioners and regulators working on the implementation of such models.