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Market-Based Solutions to Vital Economic Issues


Market-Based Solutions to Vital Economic Issues
Jan 8, 2018

Insurers as Asset Managers and Systemic Risk


Financial intermediaries often provide guarantees that resemble out-of-the-money put options, exposing them to tail risk. We present a model in the context of the U.S. life insurance industry in which variable annuity (VA) guarantees and associated hedging operate within the regulatory capital framework to create incentives for insurers to overweight high-risk and illiquid bonds (“reach-for-yield”). We then calibrate the model to insurer-level data, and show that, in the event of shocks to asset values or guarantees, the VA-writing insurers’ collective allocation to illiquid bonds exacerbates system-wide fire sales to maintain capital ratios, plausibly erasing up to 16-89% of insurers’ equity capital.

Note: Research papers posted on SSRN, including any findings, may differ from the final version chosen for publication in academic journals.

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