Insurers as Asset Managers and Systemic Risk

Asset fire sales arguably play a critical role in the propagation of systemic risk. We propose a new mechanism whereby financial institutions’ business models engender correlated asset portfolios, increasing vulnerability to fire-sales. We use as our laboratory the U.S. life insurance industry, which has experienced a major transformation with the significant expansion of variable annuity (VA) investment products with guarantees, against which insurers have to post reserves and regulatory capital. We develop a theoretical model in which an insurer hedges its guarantee exposure, and, as a result, is incentivized to invest in illiquid assets. In the event of an asset shock or a shock to the value of the guarantee, insurers engage in fire sales to maintain their capital ratios. Using insurer-level data, we calibrate the model and confirm that insurers operating in the VA space invest in riskier portfolios, sharing common allocations to illiquid bonds. In a simulation exercise, we subject the insurers to various shocks and show that the system-wide fire-sale costs, directly attributable to VAs, can plausibly erase up to 30% of the insurers’ total capital and surplus. Given the widespread nature of potentially underfunded guarantees (e.g., pension funds), the implications of our findings are not restricted to the insurance sector.