Insurers as Asset Managers and Systemic Risk

Financial intermediaries often provide guarantees that resemble out-of-the-money put options, exposing them to tail risk. We present a model in the context of the U.S. life insurance industry in which variable annuity (VA) guarantees and associated hedging operate within the regulatory capital framework to create incentives for insurers to overweight high-risk and illiquid bonds. We calibrate the model to insurer-level data, and identify the VA-induced allocation to these bonds. In the event of asset value or guarantee shocks and absent regulatory intervention, such allocation exacerbates system-wide fire sales (to maintain capital ratios), plausibly erasing 22-127% of insurers' equity capital.