Insurers As Asset Managers and Systemic Risk

Abstract

Financial intermediaries often provide guarantees that resemble out-of-the-money put options,
exposing them to tail risk. Using the U.S. life insurance industry as a laboratory, we present
a model in which variable annuity (VA) guarantees and associated hedging operate within
the regulatory capital framework to create incentives for insurers to overweight illiquid bonds
(“reach-for-yield”). We then calibrate the model to insurer-level data, and show that the VAwriting
insurers’ collective allocation to illiquid bonds exacerbates system-wide fire sales in the
event of negative asset shocks, plausibly erasing up to 20-70% of insurers’ equity capital.

Keywords: Systemic risk, Financial stability, Inter-connectedness, Financial intermediaries, Insurance companies

JEL Classification: G11, G12, G14, G18, G22