Do asset regulations impede portfolio diversification? evidence from European life insurance funds

We investigate the effects of regulatory restrictions on the amounts invested in risky asset classes in life insurance funds across EU countries. By estimating a panel data econometric model, we find that these restrictions have an economically and statistically significant negative impact on risk-adjusted returns of approximately 1-2 percentage points, holding constant other relevant factors. The use of explicit limits on asset allocation can be a blunt instrument for regulating risk-taking, in that they impede investment managers’ ability to exploit the benefits of portfolio diversification, and thus distort portfolio selection below the efficient frontier. We also find that those countries which impose the most stringent constraints tend to experience the largest efficiency losses. Furthermore, our results suggest that firms subject to prescriptive regulation are less able to respond quickly under conditions of financial market turbulence. Our results are robust to inclusion of additional controls, tests for fixed effects and country-specific heterogeneity, and other robustness checks.