The Fragility of Market Risk Insurance

Transcription

1 The Fragility of Market Risk Insurance Ralph S.J. Koijen a Motohiro Yogo b a New York University, NBER, and CEPR b Princeton University and NBER 1 / 26

2 Liabilities of U.S. financial institutions in 2015 Liability Trillion $ Mutual funds 12.9 Savings deposits 8.0 Life insurance 5.9 Private DC plans 5.4 Private DB plans 3.1 The majority of the insurance literature studies demand-side frictions such as adverse selection and moral hazard. Yaari (1965) and Rothschild and Stiglitz (1976). Little work on supply-side frictions: Financial/regulatory frictions (corporate finance) and market power (IO) that affect the production of retirement savings products. 2 / 26

3 Composition of life insurance liabilities Liability Trillion $ Separate accounts (variable annuities) 1.8 Life insurance 1.5 Traditional annuities 1.0 Pension fund liabilities 0.7 Other reserves (accident & health) 0.3 Risk sharing functions of life insurers: 1. Diversify most important sources of idiosyncratic risk. 2. Market risk insurance: Smooth aggregate risk over time or across investors, taking on the traditional role of pension plans and Social Security. 3 / 26

4 Questions 1. What do life insurers insure? Market risk through guaranteed return products. Variable annuity = Mutual fund + Long-dated put option $1.5 trillion or 42% of U.S. life insurer liabilities in / 26

5 Questions 1. What do life insurers insure? Market risk through guaranteed return products. Variable annuity = Mutual fund + Long-dated put option $1.5 trillion or 42% of U.S. life insurer liabilities in How do they insure market risk? Supply-side frictions: Risk-based capital constraint and market power. 3. Impact of aggregate shocks? After the 2008 financial crisis Pricing: Fees spiked and sales fell. Contract characteristics: Guarantees became less generous and some insurers exited to limit risk exposure. Move liabilities off balance sheet through reinsurance. 4 / 26

6 Example: MetLife Series VA Sold by MetLife Insurance Company USA. American Funds Growth Allocation Portfolio: Mutual fund with a target equity allocation of 70 85%. Annual base contract expense of 1.3%. Guaranteed Lifetime Withdrawal Benefit: Optional minimum return guarantee with Annual fee of 0.5%. Roll-up rate (guaranteed return) of 5%. Withdrawal rate of 5%. 5 / 26

7 Example of a guaranteed living withdrawal benefit Dollars Withdrawal at 5% Account value 2008:4 2010:4 2012:4 2014:4 2016:4 Date 6 / 26

8 Example of a guaranteed living withdrawal benefit Dollars Withdrawal at 5% Account value Rollup rate of 5% 2008:4 2010:4 2012:4 2014:4 2016:4 Date 7 / 26

9 Example of a guaranteed living withdrawal benefit Dollars Withdrawal at 5% Account value Rollup rate of 5% Guaranteed amount 2008:4 2010:4 2012:4 2014:4 2016:4 Date 8 / 26

10 How are variable annuities regulated? Insurance regulators and rating agencies use the risk-based capital ratio: RBC = Assets Reserves Required capital The value of VA guarantee (put option) increases with lower stock prices, lower interest rates, and higher volatility. 1. Reserves increase because of revaluation. 2. Required capital increases because of increased risk exposure. An empirical measure of the value of VA guarantees: Reserve valuation = Reserves Account value 9 / 26

11 Why is there risk mismatch? Guarantees and mutual funds offered vary across insurers. Why do insurers not perfectly hedge the risks in the liabilities? 1. Life insurers may not want to fully hedge VA risk. Risk shifting under limited liability and guaranty funds. Hedge positions differ depending on whether life insurers hedge economic, statutory, or GAAP capital. 2. Imperfect hedging because of model uncertainty. 3. Limited supply of long-dated puts. Someone has to hold aggregate risk, and life insurers may have comparative advantage over other institutions. 10 / 26

12 Data on the variable annuity market Morningstar (1999:1 2015:4): Quarterly contract-level data on sales, fees, and characteristics. Different types of guaranteed living benefits. NAIC General Interrogatories Part 2 Table 9.2 ( ): Annual data on VA account value, reserve value, and amount of reserves reinsured. A.M. Best Company ( ): Annual financial statements. Life insurer characteristics: A.M. Best rating, risk-based capital ratio, log liabilities, and VA share of liabilities. 11 / 26

13 Summary statistics for the variable annuity market VA liabilities Number Reserve % of total of valuation Year Billion $ liabilities insurers (%) , , , , , , , , , , , / 26

14 Variable annuity sales 45 Variable annuity sales (billion $) Mutual fund sales (billion $) 400 Variable annuity sales (billion $) Mutual fund sales (billion $) :4 2002:4 2005:4 2008:4 2011:4 2014:4 Year: Quarter / 26

15 Number of life insurers by type of guaranteed living benefit Number of insurers Number of contracts Number of insurers Number of contracts :4 2002:4 2005:4 2008:4 2011:4 2014:4 Year: Quarter / 26

16 Guaranteed living benefit fees Fee (%) :4 2002:4 2005:4 2008:4 2011:4 2014:4 Year: Quarter 15 / 26

17 Roll-up rates for guaranteed living benefits 6 5 Rollup rate (%) :4 2002:4 2005:4 2008:4 2011:4 2014:4 Year: Quarter 16 / 26

18 Evidence for supply-side fragility Sales fell and fees spiked. Reduced contract variety and market incompleteness as life insurers limit risk exposure. 1. Exit from offering guarantees. 2. Roll-up rates decrease. 17 / 26

19 Evidence for supply-side fragility Sales fell and fees spiked. Reduced contract variety and market incompleteness as life insurers limit risk exposure. 1. Exit from offering guarantees. 2. Roll-up rates decrease. Supply-side hypotheses: 1. Updating of priors regarding tail risk (e.g., high market volatility or a prolonged period of low interest rates). 2. Increased valuation of existing liabilities stressed risk-based capital. In the cross-section, life insurers that experienced larger increases in reserve valuation should Reduce sales more. Move liabilities off balance sheet through reinsurance. 17 / 26

20 Sales growth versus change in reserve valuation 100 Prudential Thrivent Financial for Lutherans Offered GLWB in 2007: Yes No Sales growth (%) 50 0 Northwestern Ohio National Life Aegon New York Lincoln Life Metropolitan Life Jackson AIG National Fidelity Investments Nationwide Allianz MassMutual Pacific Ameriprise Life Security Benefit Hartford Voya John Hancock Genworth Change in reserve valuation AXA 18 / 26

21 Change in percentage of reserves reinsured versus change in reserve valuation 90 Change in percentage of reserves reinsured Nationwide AIG New Thrivent Northwestern Allianz MassMutual Pacific York Ameriprise Financial Life Security for Benefit Lutherans Lincoln Jackson National Prudential Metropolitan Life Hartford Voya Aegon Genworth John Hancock Change in reserve valuation AXA Offered GLWB in 2007: Yes No 19 / 26

22 A model of variable annuity supply Key frictions: 1. Risk-based capital regulation: Issuance of new contracts reduces risk-based capital. 2. Market power: Insurers compete by Bertrand pricing in an oligopolistic market. In response to an adverse shock to risk-based capital, an insurer 1. Increases prices. 2. Changes contract characteristics (or exits entirely) to limit risk exposure. We use the model to decompose price changes into changes in market power and marginal cost. 20 / 26

23 Estimated model of variable annuity demand Standard Variable Mean deviation Fee (0.16) (0.10) Rollup rate 0.90 (0.29) Investment options 0.06 (0.01) A.M. Best rating (0.24) (0.18) Risk-based capital (0.07) Log liabilities (0.24) VA share (0.25) Observations 9, / 26

24 Variable annuity fees and marginal cost 2.4 Fee Marginal cost 2.2 % of account value :4 2008:4 2011:4 2014:4 Year: Quarter 22 / 26

25 Changes in fees and marginal costs from 2007 to 2009 Marginal Insurer Fee cost Hartford Metropolitan Life Sun Life Aegon AXA Voya Prudential AIG Genworth Ameriprise Pacific Life Nationwide John Hancock / 26

26 Consumer surplus from the variable annuity market.12.1 Surplus per $1 investment :4 2008:4 2011:4 2014:4 Year: Quarter 24 / 26

27 Supply-side theory of insurance Traditional view Supply-side view Products Health/life insurance Guaranteed return & traditional annuities products Insures Idiosyncratic risk Market risk across states across time Frictions Informational Financial/regulatory & market power Consequences Variation in prices, contract characteristics & degree of market incompleteness 25 / 26

28 Broader issues Mutual funds traditionally pure pass-through institutions with no risk mismatch. Growing part of the mutual fund sector sold through life insurers is subject to risk mismatch. Similar problem to persistent under-funding of pension funds, but with additional market discipline for publicly traded companies. Guaranteed return products are a significant share of life insurer liabilities in Austria, Denmark, Germany, Netherlands, and Sweden (ESRB 2015). A potential issue to monitor for financial stability. 26 / 26