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Session Chair: Alexander Braun, University of St.Gallen
Life insurance convexity
Christian Kubitza1, Nicolaus Grochola2, Helmut Gründl2
1University of Bonn, Germany; 2Goethe University Frankfurt am Main, Germany
Discussant: Hato Schmeiser (University of St.Gallen)
Life insurers massively sell savings policies that guarantee minimum withdrawal payouts. When market interest rates increase, these guarantees become in-the-money. Hence, an increase in interest rates leads to more withdrawals of life insurance policies. We document this effect by exploiting partly hand-collected insurer-level data covering more than two decades. A one-standard deviation increase in interest rates relates to an increase in withdrawal rates by roughly 0.35 standard deviations. As a result, the duration of life insurance policies decreases with higher interest rates. A reduction in duration implies that life insurers may be forced to sell assets when interest rates rise. We build a granular model of life insurers' cash flows to estimate the resulting price impact and fire sale costs. Under plausible assumptions, the model predicts that forced sales reduce asset prices by up to 1% and reduce insurers' equity capital by up to 15bps. Forced sales are primarily driven by insurers' long-dated assets investments, which slow down an increase in policy returns when interest rates rise.
Internal Models, Make Believe Prices, and Bond Market Cornering
Ishita Sen1, Varun Sharma2
1Harvard Business School, United States of America; 2London Business School, United Kingdom
Discussant: Alexander Braun (University of St.Gallen)
Exploiting position-level heterogeneity in regulatory incentives to misreport and novel data on regulators, we document that U.S. life insurers inflate the values of corporate bonds using internal models. We estimate an additional $9-$18 billion decline in regulatory capital during the 2008 crisis, i.e., a 30% greater decline than what was reported. Supervision helps dissuade misreporting, but only when close pricing benchmarks exist. Insurers, in response, strategically shift asset selection toward bonds where price verification is harder, and corner small bonds. Our findings have consequences for assessing the fragility of financial institutions and for understanding the price discovery of corporate bonds.