Life insurers support their life insurance policies and annuities with trillions of dollars in investments.
Insurance regulators and insurance financial strength rating agencies encourage life insurers to invest in large, diversified portfolios of high-quality corporate bonds, with a sprinkling of mortgages, mortgage-backed securities, and securities backed by assets such as private equity investments, hedge fund investments, or credit card payment streams, to add some excitement.
Now four economists are suggesting that encouraging many big financial institutions to all invest in the same way may actually increase the risk that the whole financial system will have problems, by increasing the odds that the financial institutions will rush to sell assets at the same time.
- A copy of investment heterogeneity paper is available here.
- An article about life and annuity issuers’ headwinds is available here.
Itay Goldstein, a researcher at the University of Pennsylvania’s business school, and three colleagues at other universities have published the paper, as a working paper, on the website of the National Bureau of Economic Research.
A working paper is a paper that has not yet been through a full peer review process.
Goldstein and his colleagues focused on banks, and the risk that banks will face bank runs, rather than on life insurers.
Life insurers have argued that they are less prone to “runs,” or sudden spikes in customer demands to withdrawal cash, because life and annuity products are usually designed to spread any need to return cash to the customers out over time.
But many life insurers use big derivatives arrangements, or contracts with values tied to the performance of investment market indexes or other financial instruments. Depending on how life insurers have set up their derivatives arrangements, they could face a sudden increase in the need for cash to top off the pots of collateral used to support the derivatives arrangements. The derivatives counterparty collateral watchers are the ones who, in effect, may mount runs on the life insurers.