By Force of Habitat? A First Look at Insurers' Government Bond Portfolios

Abstract:     
The preferred habitat hypothesis links the shape of the term structure to inelastic demand in the bond market and is regarded as the theoretical underpinning of recent monetary policies. This study provides microeconomic level evidence of habitat in the portfolios of an important group of government bond investors -- insurance firms. Using a simple dynamic portfolio model we highlight two forms of habitat that are due to two hedging components in an institutional investor's portfolio, one against the interest rate risk associated with liability and another against the interest rate risk associated with investment horizon. Empirically, we find that insurers' portfolio durations are strongly related to their liability characteristics, such as the ratio of claim-related liabilities to total investments and the durations of claim-related liabilities. Liability concerns also dampen portfolio response to term structure changes. However, the evidence on the investment horizon effect is mixed; and if any, insurers' investment horizon appears relatively short. These findings highlight the importance of institutional investors' liability structure in causing inelasticity of bond demand.

Number of Pages in PDF File: 52

working papers series