The Role of Financial Conditions in Portfolio Choices: The Case of Insurers
Charles A. Dice Working Paper No. 2019-06
59 Pages Posted: 14 Mar 2019 Last revised: 16 May 2019
Date Written: May 8, 2019
Many institutional investors depend on the returns they generate to fund their operations and liabilities. How does these investors’ demand for capital affect the management of their portfolios? We address this issue using the insurance industry because insurers are large investors for which detailed portfolio data are available, and can face financial shocks from exogenous weather-related events. We find that insurers with more financial flexibility have larger portfolio weights on riskier and more illiquid assets, and have higher realized returns. Among corporate bonds, for which we can control for regulatory treatment, we find that more financially flexible insurers have larger portfolio weights on riskier and more illiquid corporate bonds. Following losses, P&C insurers decrease allocations to riskier corporate bonds. The effect of losses on allocations is likely to be causal since it holds when instrumenting for P&C losses with weather shocks. The change in allocations following losses is larger for more financially constrained insurers and during the financial crisis, suggesting that the shift toward less risky securities is driven by concerns about financial flexibility. The results highlight the importance of financial flexibility to fund operations in institutional investors’ portfolio decisions.
Keywords: Financial constraints, investment, insurer, financial portfolio, asset allocation, risk, liquidity
JEL Classification: G11, G22, G23, G31, G32
Suggested Citation: Suggested Citation