Did Insurers Become Risk-Loving During “Low-for-Long”? The Role of Returns, Ratings, and Regulation

DidInsurersBecomeRisk-LovingDuring“Low-for-Long”? TheRoleofReturns,Ratings,andRegulation JeroenBrinkhoffandJuanSoléWP/22/202 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2022 SEP ©2022InternationalMonetaryFundWP/22/202 IMFWorkingPaper MonetaryandCapitalMarketsDepartment DidInsurersBecomeRisk-LovingDuring“Low-for-Long”? TheRoleofReturns,Ratings,andRegulationPreparedbyJeroenBrinkhoffandJuanSolé* AuthorizedfordistributionbyRanjitSingh September2022 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Europeanlifeinsurancecompaniesareimportantbondinvestorsandhadtraditionallyplayedastabilizingroleinfinancialmarketsbypursuing“buy-and-hold”investmentstrategies.However,sincetheonsetoftheultra-lowinterestrateserain2008,observersnotedadeclineinthecreditqualityofinsurers’bondportfolios.Thecommonly-heldexplanationforthisdeteriorationisthatlowreturnspushedinsurerstobecomemorerisk-taking.Wearguethatotherfactors—suchassurgingratingdowngrades,bondrevaluations,andregulatorychanges—alsoplayedakeyrole.Weestimatethatratingchanges,revaluations,andsearchforyieldeachaccountforaboutone-thirdeachofthetotaldeteriorationincreditquality.Thisresulthasimportantpolicyimplicationsasitreestablishestheviewthatinsurers’investmentbehaviortendstobepassivethroughthecycle—ratherthanrisk-seeking. JELClassificationNumbers: E43,G11,G12,G22 Keywords: LifeInsurancesector;financialstability;creditratings. Author’sE-MailAddress: j.brinkhoff@dnb.nl;jsole@imf.org *WeareindebtedtoPeteDattels,MatthewJones,FabioNatalucci,RanjitSingh,NobuSugimotoandNicolaPierrifornumerouscommentsandsuggestionsonearlierdrafts.Allremainingerrorsaretheresponsibilityoftheauthors. WORKINGPAPERS DidInsurersBecomeRisk-LovingDuring“Low-for-Long”? TheRoleofReturns,Ratings,andRegulation PreparedbyJeroenBrinkhoffandJuanSolé1 1WeareindebtedtoFabioCortés,PeteDattels,MatthewJones,FabioNatalucci,NicolaPerri,RanjitSingh,andNobuSugimotofornumerouscommentsandsuggestionsonearlierdrafts.Allremainingerrorsaretheresponsibilityoftheauthors. Contents I.Motivation3 II.TheChangingCreditQualityofInsurers’BondPortfolios,2005-20214 III.QuantificationofthePortfolioDrivers8 IV.Data9 V.Results9 VI.RobustnessChecks12 VII.AssumptiononCorporatevs.SovereignBondsSplit12 VIII.AssumptionontheDurationofCorporateandSovereignBonds14 IX.ConcludingRemarks16 References17 I.Motivation Europeanpolicyratesweredramaticallyslashedinlate2008inresponsetotheunfoldingglobalfinancialcrisisof2008-09,andthenagainbetween2011and2014onthebackoftheEuropeandebtcrisis.Theseverityofthesecrisesmeant,however, thateventhesehistoricallyultra-lowpolicyratesoflessthan1percentprovedinsufficienttospureconomicandcreditgrowth,forcingcentralbankstousherinaperiodofunconventionalmonetarypolicies:Mostnotablyvialargeacquisitionsofsovereignandcorporatebonds.Thesepurchaseprogramscompressedinterestratesevenfurtherandforalongtime,givingrisetotheperiodnowknownasthe“low-for-long”era(textfigure). Confrontedwithanemicreturns,institutionalinvestorssoughttoboosttheirprofitsbyventuringintoincreasinglyriskierandlessliquidassetclasses.Atthetime,suchbehaviorwassuspectedamongalltypesofinvestors,includingtraditionallyconservativeoneslikelifeinsurancefirmsandpensionfunds.Infact,severalobserversdocumentedanincreaseininsurers’investmentsintolessliquidassetsandriskierbonds—huntingforyield(IMF,2015and2017)—andalengtheningofthedurationoftheseinvestments—huntingforduration(Domanskietal.2017).1 Andso,itbecamecommonlyacceptedthattheprincipalreasonbehindtheworseningqualityofinsurers’bondportfoliosduringthelow-for-longwasamoreaggressivesearchforyield.Onthebackofthisperception,lifeinsurersceasedtobeviewedasastableinvestorclassandbecamethefocusofsector-widestresstests(e.g.,EIOPA2014and2016),quantificationsofthepotentialimpactthattheirdistresscouldhaveonfinancialstability(Joyceetal.,2014,andESRB2015,amongothers),aswellasstudiesoninsurers’tradingbehavior(EIOPA,2020). However,therewereotherdevelopmentsduringthisperiodthatcouldalsoexplainthechangesininsurers’portfolios.First,theglobalfinancialandEuropeandebtcrisesledtoamulti-yearsurgeinthenumberofcorporateandsovereignratingdowngrades,whichwould,inturn,worsentheoverallcreditqualityofexistingportfoliosevenifinsurershadnotacquiredmorelower-qualityassets.Second,fallinginterestrateswould 1Itisimportanttoremarkherethat,toourknowledge,evidenceofhuntfordurationhasonlybeenprovidedforGermanlifeinsurersinDomanskietal.(2017).EIOPA(2014and2018)showthatonaverage,between2014and2018,Europeaninsurersslightlydecreasedthedurationofsovereignbondinvestmentswhileslightlyincreasingthedurationofcorporatebondinvestments(seeSectionIV.Bforafurtherdiscussion).The