Volatility adjustment flaw incentivises risky investments by insurers

The ability to mismatch spread duration of assets and liabilities opens the door for arbitrage

A "fundamental flaw" in the Solvency II volatility adjustment (VA) encourages insurers to hold riskier credit assets without increasing their capital charges, bankers and insurers say.

The VA permits firms to factor in some degree of the spread derived from a currency- and country-based reference portfolio of assets into the risk-free rate used to discount their liabilities, lowering the amount of regulatory capital they need to hold. Yet because an insurer's eligibility to use the VA does not