Working Paper: CEPR ID: DP12849
Authors: Jotikasthira Chotibhak; Andrew Ellul; Anastasia Kartasheva; Christian Lundblad; Wolf Wagner
Abstract: Financial intermediaries often provide guarantees that resemble out-of-the-money put options, exposing them to tail risk. Using the U.S. life insurance industry as a laboratory, we present a model in which variable annuity (VA) guarantees and associated hedging operate within the regulatory capital framework to create incentives for insurers to overweight illiquid bonds ("reach-for-yield"). We then calibrate the model to insurer-level data, and show that the VA-writing insurers' collective allocation to illiquid bonds exacerbates system-wide fire sales in the event of negative asset shocks, plausibly erasing up to 20-70% of insurers' equity capital.
Keywords: systemic risk; financial stability; interconnectedness; insurance companies
JEL Codes: G11; G12; G14; G18; G22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Variable annuity guarantees (G52) | Overweight illiquid bonds (G33) |
| Overweight illiquid bonds (G33) | Reaching for yield behavior (G11) |
| Reaching for yield behavior (G11) | Increased systemic risk (F65) |
| Shock to the equity market (G10) | Fire sales (G33) |
| Fire sales (G33) | Increased systemic risk (F65) |
| Variable annuity guarantees (G52) | Fire sales (G33) |
| Variable annuity guarantees (G52) | Increased systemic risk (F65) |