Journal of Risk

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Optimal equity protection of Solvency II regulated portfolios

Benoit Vaucher

  • Solvency II regulations encourage the use of derivatives to protect portfolios so as to reduce capital charges. For owners of equity portfolios, buying protection in the form of protective put options is particularly interesting as capital charges for this important asset class are high.  
  • Because protecting portfolios reduce capital charges, Solvency II regulations introduce an external utility that changes the economic value of put options. We found that not only Solvency II regulations change the net cost of options, but that there is an optimal way to choose options so as to reduce the net cost of protecting portfolios.
  • Our research also shows that buying protection is cheaper when capital charges are calculated using risk-based rather than more common shock-based methodologies.

The Solvency II regulatory framework creates incentives for using derivatives to mitigate risk. However, for investors willing to reduce capital charges by protecting their portfolio against losses, very few practical solutions exist. In the context of equity investments, we examine the relationship between the cost of acquiring protection (in the form of a put option) and the reduction of capital charges that it entails. We develop the idea that Solvency II regulations introduce an external utility that modifies the economic value of options. Using these findings, we show that there is a way to choose protection levels that maximizes reductions in capital charges for every dollar spent on the put options. We provide results for both risk-based and drawdown-based capital requirements and argue that risk-based capital requirements offer even greater incentives for using derivatives in the context of risk mitigation.

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