Since the financial crisis of 2008-09, risk across the financial system continues to worry investors and policymakers. According to new research by Finance Professor Chotibhak Jotikasthira and his co-authors, “systemic risk” may arise from the interconnectedness of the asset side of financial institutions’ balance sheets. They reveal how a similarity of assets across insurers emerges from their business decisions to provide (and hedge) investment products, namely variable annuities (VAs) with guarantees.

“The origin of our paper stems from looking at a MetLife case that determines whether large insurers are considered systemically risky,” Jotikasthira explained. “They argue they are not. In reality, with VAs consisting of more than a third of some insurers’ liabilities, they delve into riskier behaviors versus traditional lines.” These new types of policies expose insurers to nondiversifiable market risk and can inherently create asset interconnectedness and systemic risk, he said.

“We are the first to link the variable annuity risk to the interconnectedness of assets and systemic risk,” Jotikasthira offered. Over the last two decades, major product lines of insurers have evolved from traditional life insurance to asset management products, and particularly variable annuities. Only a few life insurers underwrite VAs, say the authors, and the ones that do tend to be very large.

“Over the last two decades, major product lines of insurers have evolved from traditional life insurance to asset management products, and particularly variable annuities.”

The insurers’ exposures to financial guarantees on stock market performance create incentives to “reach for yield” by overweighting similar, illiquid assets in their portfolios. The portfolio overweight on riskier bonds becomes problematic during a market downturn. As all insurers writing guarantees are exposed to the stock market shock at the same time, the need to sell illiquid bonds is also correlated among insurers, resulting in a fire-sale effect. Under different extreme scenarios, these dynamics can plausibly erase between 20 and 70 percent of insurers’ aggregate equity capital. The consequence is contagion to other insurance companies and to the broader financial system. Interestingly, the research finds that the largest culprit of systemic risk is the reaching for yield behavior rather than the net VA guarantee exposures per se. “VAs can lead to excessive risk-taking behavior,” Jotikasthira concluded.