A Proposal for an Interest Rate Dampener for Solvency II to Manage Pro-Cyclical Effects and Improve Asset-Liability Management

The aim of this study is to propose the introduction of a Dampener adjustment in the risk measure for bond instruments — which takes economic cycles into account. Firstly, we have revisited the regulator’s chosen method for measuring bond risk (bond Solvency Capital Requirement), highlighting the main limitations, and thereby showing the need for an equity-type dampener within the regulatory bond risk measure. Secondly, we have built a proposal of a Dampener model based on a three-factor mean reversion which reduces the pro-cyclical effect of the Solvency II standard formula.