Abstract: I construct a long history of risk exposures from derivatives using position-level data on interest rate and equity instruments to show that inconsistencies in regulation limit the hedging choices of US life insurers. I exploit a shift in the regulation that provides inconsistent incentives to hedge economically similar products due to differences in the sensitivity of regulatory capital to movements in interest rates. I show that hedging increases and becomes more sensitive to interest rate fluctuations for insurers that underwrite products that became risk sensitive under the new regulation. However, insurers that underwrite products that have similar economic exposures but no regulatory sensitivity to interest rates do not increase hedging but instead increase off-balance sheet transfers. Consistent with regulation limiting hedging choices, tighter regulatory constraints lead to lower hedging. Using data on collateral posted to counter-parties, I show that lower hedging is not due to collateral constraints. My findings have implications for the fragility of life insurers as regulation interacts with monetary policy to make the framework insensitive when interest rates rise.
Co-author: David Humphry (Bank of England)
Abstract: This paper examines the impact of the introduction of a risk-based capital regulation regime in 2002 on product market outcomes for the insurance industry in the UK. Using proprietary data on stress-test submissions from the Bank of England, we develop a measure of firm-level shocks to regulatory constraints that is plausibly exogenous to shifts in insurance demand. We find that constrained firms reduced underwriting relative to unconstrained firms, particularly for traditional insurance products which became more capital intensive in the new regulatory regime. The reduction in underwriting was not as pronounced for linked products, products that are mainly investment vehicles like mutual funds, implying a shift in the equilibrium product mix from traditional to linked. We also show that a higher proportion of constrained firms restructured their balance sheets by transferring assets and liabilities and went through reorganizations i.e. a change in legal owner of the firm.
Internal Models and Make Believe Pricing
Co-author: Varun Sharma (London Business School)
Abstract: Using corporate bond holdings of U.S. life insurers, we show that life insurers used internal models to over-report the value of a large fraction of corporate bond assets during the financial crisis. Reported credit spreads of bonds valued using internal models were substantially lower by 220 bps, as compared to bonds that are otherwise similar but valued using external sources. Misreporting is higher for bonds that are likely to be impaired and negatively affect regulatory ratios and for insurers that are constrained by regulatory capital. We document significant heterogeneity in misreporting across U.S. states and show that it correlates with the strictness of the state regulator during the crisis. Consequently, we show that there is greater misreporting in positions that are held by fewer insurers, as concentrated holdings helps to minimize regulatory scrutiny. Our findings have implications for the ex-ante portfolio choice of insurers, which impacts the micro-structure of a segment of the corporate bond market, and for properly assessing the fragility of financial institutions in bad times.
Works in Progress
Pricing Corporate Bonds: An Institutional Approach
Abstract: This paper examines whether the institutional pricing model implied by an insurance fund manager's portfolio optimization problem prices the cross-section of corporate bond returns. I present a stylized portfolio choice problem of an insurance company which faces realistic regulatory risk constraints. I test this model for the corporate bond market using data on insurance companies' balance-sheet and corporate bond returns and study the model's implications on asset prices, manager's incentives, and risk preferences. I find that both aggregate fluctuations in balance-sheet assets and dispersion of shocks across firms matter for asset pricing. I also show that the manager's incentives with respect to regulatory capital charge of an asset is large and statistically significant and establish that the marginal value of regulatory capital charge is time-varying and increases during economic downturns.