Systemic Risk in the Insurance Sector under Solvency II: An Analysis of the Pro-Cyclicality Channel

Abstract: This thesis studies the effect of a change in the regulatory environment on the cyclicality of insurers' investment behavior. Given their large amount of asset holdings, insurers have the potential to reinforce or dampen market and asset price movements. While their long-term investment horizon theoretically puts insurers in a position to act as stabilizers on financial markets, the regulatory framework could incentivize a pro-cyclical investment allocation. This in turn could lead to an enlarged contribution of insurers to systemic risk through the pro-cyclicality channel. The recently implemented Solvency II regulation, which introduced mark-to-market accounting standards and risk-based capital requirements for European insurance undertakings, provides an ideal setting to analyze the impact of a regulatory change on the cyclicality of an insurer's investment decisions. Using unique security level data and applying a difference-in-differences approach, this thesis finds evidence that Solvency II incentivized German insurers to act slightly more pro-cyclical relative to pension funds, which are used as a control group. Being one of the first studies to compare the cyclicality of insurers' asset allocation under different regulatory frameworks, this thesis provides policymakers with first indicative insights on the effects of Solvency II on the pro-cyclicality channel of systemic risk.