Potential impact of Solvency II on equity derivatives markets

Solvency II (European Union insurance company regulations) is a major regulatory theme for financial markets through 2011 and beyond. Under Solvency II, insurers will be forced to hold sufficient capital, as measured by the Solvency Capital Requirement (SCR), to remain solvent during periods of market and insurance stress. Consequently, there is increased linkage between capital requirements (and cost of capital) and the price of risk embedded in market assets. Combined with the extensive size of insurers’ asset holdings, any alteration in their operating environment has the potential to alter not only the behaviour of those institutions directly involved but also wider asset pricing and market structure. This is particularly true for equity derivatives prices, which are highly sensitive to supply/demand balance. For this reason, we believe it is useful for all investors – not just those in the insurance industry – to understand Solvency II and its implications.