Optimal Asset Allocation for Interconnected Life Insurers in the Low Interest Rate Environment under Solvency Regulation

I assess how Basel III, Solvency II, and the low interest rate environment willaffect the financial connection between the bank and insurance sectors by changingthe funding patterns of banks as well as the investment strategies of life insurancecompanies. Especially for life insurance companies, the current low interest rateenvironment poses a key risk since declining returns on investments jeopardize theguaranteed return on life insurance contracts, a core component of traditional lifeinsurance contracts in several European countries. I consider a contingent claimframework with a direct financial connection between banks and life insurers via bankbonds. The results indicate that life insurers’ demand for bank bonds increases overthe mid-term but ultimately declines in the long-run. Since life insurers are the largestpurchasers of bank bonds in Europe, banks could lose one of their main fundingsources. In addition, I show that shareholder-value-driven life insurers’ appetite forrisk increases when the gap between asset return and liability growth diminishes. Tocheck the robustness of the findings, I calibrate a prolonged low interest rate scenario.The results show that the insurer’s risk appetite is even higher when interest ratesremain persistently low. A sensitivity analysis regarding industry-specific regulatorysafety levels reveals that contagion between bank and life insurer is driven by theinsurers’ demand for bank bonds, which itself depends on the regulatory safety levelof banks.