Since the financial crisis of 2008-09, risk that spreads across the financial system continues to worry investors and policymakers. This “systemic risk” may arise from the inter-connectedness of the asset side of financial institutions’ balance sheets, according to new research. Finance Professor Chotibhak Jotikasthira of SMU Cox and co-authors reveal how asset similarity across insurers arises from their business decisions to provide (and hedge) investment products, namely variable annuities (VAs) with guarantees.
According to Jotikasthira, “We are the first to link the variable annuity risk to the interconnectedness of assets and systemic risk.” Over the last two decades, insurers major product lines have evolved from traditional life insurance to asset management products, particularly VAs. Annuity premia and deposits earned by the U.S. life insurance industry increased from $286 billion in 2010 to $353 billion in 2014, one of the fastest growing areas of policy generation; they accounted for almost 35% of U.S. life insurers’ liabilities in 2015.
About the paper “Insurers as Asset Managers and Risk,” Jotikasthira explains: “The origin of our paper stems from looking at a MetLife case which determines whether large insurers, such as MetLife, are considered systemically risky. They argue they are not. In reality, with VAs consisting of more than a third of some insurers’ liabilities, they delve into riskier behaviors versus traditional lines.” These new types of policies they underwrite, besides exposing them to non-diversifiable market risk, can inherently create asset interconnectedness and systemic risk, Jotikasthira surmises.
The insurers’ exposures to financial guarantees on stock market performance create incentives to “reach for yield” by overweighting similar, illiquid assets in their portfolios. During a period of stock market stress, an individual insurance company may be forced to sell its assets to re-gain financial health and meet regulatory thresholds. This will impose consequences for other institutions – not only insurers - holding similar assets. Contagion will result and systemic risk emerges. Additionally, core financial sectors have become highly linked over the past decade.
Jotikasthira and co-authors contribute to an understanding of the impact of financial guarantees on financial stability. Their analysis shows how guarantees, pervasive throughout the financial system, including pension funds, can generate fire sales and systemic risk. “While banks’ systemic risk measure spiked during the 2008-2009 financial crisis, it then decreased over time,” they write. “However, the same measure for insurers selling VAs with guarantees increased during the crisis, and has not decreased in the same manner.”
Risk’s path exposed
As the U.S. retirement landscape has moved away from employer-sponsored defined benefit plans, the VA business has grown to fill part of this gap. Only few life insurers underwrite VAs, say the authors, and the ones that do tend to be very large. As a safeguard, capital regulation forces insurers to set aside reserves associated with any guarantees they have written. The size of the reserves associated with guarantees, now among the largest liabilities on insurers’ balance sheets, fluctuates with stock market performance and interest rates.
The portfolio overweight on riskier bonds becomes problematic during a market downturn. Importantly, as all insurers writing guarantees are exposed to the stock market shock at the same time, the need to sell illiquid bonds is also correlated among insurers, resulting in a fire-sale effect. Under different extreme scenarios, these dynamics can plausibly erase up to 20-70% of insurers’ aggregate equity capital. The consequence is contagion to other insurance companies and to the broader financial system.
In the authors’ empirical work, they used the regulatory filings data collected by the National Association of Insurance Commissioners (NAIC). Insurers that underwrite a substantial amount of VAs with guarantees (and delta-hedge their exposures) were found to disproportionately tilt their portfolios towards higher-yielding illiquid bonds. Delta-hedging is the short selling of equities and investing the proceeds in bonds. The hedging of guarantees creates incentives to reach for yield within the bond portfolio.
“VAs can lead to excessive risk-taking behavior,” Jotikasthira notes. “Regulators can use capital requirements as a way to prevent this from happening. Maybe there should be some type of extra capital charge for insurers who write more VA policies.”
Search for yield
Interestingly, the research finds that the largest culprit of systemic risk is the reaching for yield behavior rather than the net VA guarantee exposures per se. The overweight toward illiquid assets in the bond portfolio is a central component of the story. Insurers with greater VA exposure are the largest firms, representing roughly 50% of assets of the life insurance industry in the U.S.
The analysis sheds light on the incentives and consequences of other guarantees that are pervasive throughout the financial system. For example, the research demonstrates that negative shocks to the equity market of 10-40% would result in insurers selling $114-$458 billion of illiquid bonds; the corresponding system-wide fire sale costs would represent up to 21% of insurers' total equity capital.
Given the expansion of the life insurance industry into asset management, insurers are now more likely to contribute to systemic risk through correlated fire-sales of illiquid bonds. Regulators need to put more emphasis on developing appropriate liquidity monitoring tools and liquidity regulation. The study explains the transmission mechanism and develops practical tools to quantify the fire sale risk.
“The relatively new types of policies insurers underwrite can inherently create interconnectedness and systemic risk,” Jotikasthira concludes. He notes that in the international arena, the Financial Stability Authority regulates the 10 largest global insurers as systemically risky entities. Currently, there is pushback from insurers in the U.S. regarding this type of oversight.
The paper “Insurers as Asset Managers and Systemic Risk,” written by Chotibhak Jotikasthira of Southern Methodist University’s Cox School of Business; Andrew Ellul of Indiana University; Anastasia Kartasheva of the International Association of Insurance Supervisors, Bank for International Settlements; Christian Lundblad of University of North Carolina, Chapel Hill; and Wolf Wagner of Rotterdam School of Management, Erasmus University, is under review.
Summary by Jennifer Warren.
