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Economists are still trying to understand how, and why, issuers of life and annuity benefits guarantees might break in a crisis.

Gabriel Chodorow-Reich, an economist at Harvard, and two colleagues, talk about life insurer failure problems in a new working paper posted earlier this month behind a paywall, on the website of the National Bureau of Economic Research.

The economists compared data from normal times with data from the “Great Recession” that hit the world in 2008 and 2009.

(Related: 5 Peeks at a Hot New Variable Annuity Guarantee Paper)

Chodorow-Reich and his colleagues found that life insurers were great insulators of asset value in normal market rainshowers.

But, when the market storms rolled in, life insurers started to leak.

The Working Paper

A “working paper” is a study that has not gone through a full peer review process and may not be ready for formal publication.

Chodorow-Reich and his colleagues have been working on the new asset insulator paper for several years. They posted an earleir version online in 2016.

A free abstract of the new version is available to the public here.

Few life or annuity prospects spend much time reading economics working papers.

But, because economic papers about life insurance and annuities are less common than papers about banks and stocks, any new paper about life insurance and annuities could make a splash.

A widely read paper could affect life insurance and annuity market rules, and life insurers’ access to investor capital, by shaping the views of rating analysts, and of analysts at federal agencies and congressional committees.

What the Economists Found

Life insurers invest heavily in corporate bonds.

Chodorow-Reich and his colleagues measured life insurers’ asset insulation power by looking at the effects of changes in corporate bond returns on life insurers’ asset-value totals, and on publicly traded life insurers’ stock prices.

Traditionally, Chodorow-Reich and his colleague writes, economists have assumed that life insurers try to make their money mainly by profiting from the risk that life insurers will die early, or that annuity holders will live too long.

In reality, Chodorow-Reich and his colleagues write, data on life insurers’ investments show that, in normal times, life insurers have an obvious incentive to hold relatively risky assets that are “illiquid,” or somewhat difficult to sell quickly, especially in a time of crisis.

In normal times, life insurers work well as asset insulators, and a $1 drop in the value of corporate bonds leads to just 15 cent drop in the value of public life insurers’ stocks, the economists write.

During the 2008-2009 crisis, however, a $1 drop in the value of life insurers’ assets led to a $1.10 drop in the total value of publicly traded life insurers’ stock, the economists write.

That does not mean that the life insurers failed, or that they defaulted on their obligations, but the financial pressures rocking life insurers increase dramatically during a crisis, the economists write.

On the other hand, the economists write, even though life insurers’ ability to insulate against market risk weakens in a financial crisis, the 2008-2009 data suggest that life insurers did cut the projected drop in life insurers’ own security holdings’ value to about $80 billion, from $126 billion.

That means that, even during the crisis, life insurer asset insulation may have helped cut total market losses by about one-third, the economists write.

“As they approach default, insurers lose the ability to insulate assets from the market,” the economists write.

But, as long as life insurers appear to be staying solvent, the life insurers’ role as insulators helps to increase the insurers’ value, the economists say.

Other economists have argued that life insurers may make economic crises worse.

Chodorow-Reich and his colleagues defend life insurers. They say they think life insurers make the economy more stable, not less stable, by providing at least some asset value insulation, even in crises.

“Proposals to tightly regulate [life insurers'] asset holdings might impair this function,” the economists write. “On the other hand, the correlation between market illiquidity and the health of the financial sector makes the asset insulation function most fragile exactly when it is most valuable.”

— Read Surviving the ‘Perfect Storm’on ThinkAdvisor.

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