On 18 May, the European Systemic Risk Board (ESRB) published a working paper called “Insurers as Asset Manager and Systemic Risk”, authored by Andrew Ellul (Indiana University), Chotibhak Jotikasthira (Southern Methodist University), Anastasia Kartasheva (IAIS), Christian T. Lundblad (University of North Carolina) and Wolf Wagner (Rotterdam School of Management). (https://www.esrb.europa.eu/pub/pdf/wp/esrb.wp75.en.pdf?5c0d39050b88421d98ef91790de4b20e)
The paper focusses on asset interconnectedness (ie financial institutions holding similar risky assets in search of higher returns) and proposes a mechanism through which financial institutions’ off-balance sheet commitments induce “reaching for yield” behaviour, asset interconnectedness, and ultimately systemic risk. The asset similarity across insurers arises from their business decision to provide (and hedge) investment products.
The paper uses NAIC data on the US life insurance industry to calibrate a model testing the way in which variable annuity (VA) guarantees and the associated hedging operate within the regulatory capital framework to create incentives for insurers to overweigh illiquid bonds. The authors show that insurers’ attempts to dynamically hedge minimum-return guarantees induce “reaching for yield” through investment in similar (illiquid) assets, thereby increasing the likelihood of collective fire sales. The authors make an explicit link between the emergence of VAs with guarantees and increased interconnectedness and systemic risk.
The paper concludes that:
- By virtue of asset interconnectedness, insurers are now more likely to contribute to contagion through regulatory-induced fire sales rather than to attenuate it by behaving as asset insulators able to absorb temporary market fluctuations.
- Regulators should perhaps be wary of the implications of asset-side vulnerability to the broader financial sector associated with various forms of financial guarantees incentivising correlated risk-taking.
While the paper is focussed on the US market, the conclusions drawn are more general than that.