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Insurance and Pension Funds

Paper Session

Friday, Jan. 6, 2023 10:15 AM - 12:15 PM (CST)

Sheraton New Orleans, Rhythms I
Hosted By: American Finance Association
  • Chair: Ishita Sen, Harvard Business School

The Economics of Lapsation

Ralph Koijen
,
University of Chicago
Hae Kang Lee
,
University of South Carolina
Stijn Van Nieuwerburgh
,
Columbia University

Abstract

We study aggregate lapsation risk in the life insurance sector. Using the regulatory reporting of historical lapse rates by life insurers, we empirically document the countercyclicality of lapsation behavior. We construct two lapsation risk factors that explain a large fraction of the common variation in lapse rates of the 30 largest life insurance companies. The first is a cyclical factor that correlates with credit spreads and employment, while the second factor is a trend factor that correlates with the level of interest rates. Using a novel policy-level database from a large life insurer, we examine the heterogeneity in risk factor exposures based on policy and policyholder characteristics. Young policyholders display more cyclical lapsation behavior, while small policies are more exposed to the trend in lapsation. We explore the implications for hedging and valuation of
life insurance contracts. Ignoring aggregate lapsation risk results in cross-subsidization
across policyholders with different lapsation risk, and in a misvaluation of life insurance
policies.

Ex-Post Loss Sharing in Consumer Financial Markets

Alexandru Barbu
,
London Business School

Abstract

Insurance companies sell consumer financial products called variable annuities that combine mutual funds with minimum return guarantees over long horizons, retaining considerable market risk. I show that the guarantees embedded in variable annuities turned deeply in the money after the financial crisis. However, over the last decade, insurers removed more than $429 billion in variable annuities by having consumers exchange them into less generous products. The more generous policies were exchanged the most. I develop a structural model of consumer exploitation in insurance markets that pins down the degree of consumer inattention and the reputational costs faced by firms. I find that 20% of consumers neglect important contract characteristics, insurers pay 13 cents in reputational costs per dollar exploited, while moving to a fiduciary standard raises reputational costs by a further 8 cents per dollar and reduces exchanges by half.

Corporate Pension Risk Transfers

Sven Klingler
,
BI Norwegian Business School
Michael Moran
,
Goldman Sachs
Suresh Sundaresan
,
Columbia University

Abstract

Between 2012 and 2022, U.S. corporate sponsors of defined benefit (DB) pension plans used pension risk transfers (PRTs) to transfer more than $150 billion pension obligations to insurance companies, thereby reducing the pool of corporate DB plan participants by 10%. We assemble a new PRT database and study the drivers and consequences of PRTs. Consistent with a simple model, the propensity to conduct a PRT is higher for firms with higher flow-through costs from their pension plans and higher burdens for paying insurance premiums to the Pension Benefit Guarantee Corporation (PBGC). Safer plan sponsors with less default risk and less volatility in their pension assets are more likely to conduct PRTs thereby increasing PBGC’s pool risk.

Insurance Companies and the Growth of Corporate Loans' Securitization

Fulvia Fringuellotti
,
Federal Reserve Bank of New York
Joao Santos
,
Federal Reserve Bank of New York

Abstract

We show that insurance companies have almost nonupled their investments in collateralized loan
obligations (CLOs) in the post-crisis period, reaching total holdings of $125B in 2019. The growth in CLOs' investments has far outpaced that of loans and corporate bonds, and was characterized by a strong preference for mezzanine tranches rated investment grade over triple-A rated tranches. We document that these phenomena reflect a search for yield behavior. Conditional on capital charges, insurance companies invest more heavily in bonds and CLO tranches with higher yields. Preferences for CLO tranches derived from tranches' higher yields relative to bonds with the same rating, and increased following the 2010 capital regulatory reform, resulting in insurance companies holding more than 40% of mezzanine tranches outstanding in 2019. In the process, insurance companies created the demand for the risky tranches that are critical to the CLO issuance.

Insurance companies have almost nonupled their investments in collateralized loan obligations (CLOs) in the post-crisis period, reaching total holdings of $125B in 2019. The growth in CLOs' investments has far outpaced that of loans and corporate bonds, and was characterized by a strong preference for mezzanine tranches rated investment grade over triple-A rated tranches. We show that insurance companies' investment preferences reflect a search for yield behavior. Conditional on capital charges, insurance companies invest more heavily in bonds and CLO tranches with higher yields. However, insurance companies prefer CLO tranches because they carry higher yields relative to bonds with the same rating. Further, these preferences increased following the 2010 capital regulatory reform, resulting in insurance companies holding more than 40% of mezzanine tranches outstanding in 2019. Finally, we document that insurance companies' demand for risky tranches played a critical role in the rise of corporate loan securitization over the last decade, and contributed positively to the returns of CLOs' equity holders.

Discussant(s)
Kent Smetters
,
University of Pennsylvania
Shan Ge
,
New York University
George Pennacchi
,
University of Illinois
Victoria Ivashina
,
Harvard University
JEL Classifications
  • G2 - Financial Institutions and Services