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

SEP Did Insurers Become Risk-Loving During “Low-for-Long”? The Role of Returns, Ratings, and Regulation Jeroen Brinkhoff and Juan Solé WP/22/202 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2022 *We are indebted to Pete Dattels, Matthew Jones, Fabio Natalucci, Ranjit Singh, Nobu Sugimoto and Nicola Pierri for numerouscomments and suggestions on earlier drafts. All remaining errors are the responsibility of the authors.© 2022 International Monetary Fund WP/22/202IMF Working Paper Monetary and Capital Markets Department Did Insurers Become Risk-Loving During “Low-for-Long”? The Role of Returns, Ratings, and Regulation Prepared by Jeroen Brinkhoff and Juan Solé* Authorized for distribution by Ranjit Singh September 2022 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: European life insurance companies are important bond investors and had traditionally played a stabilizing role in financial markets by pursuing “buy-and-hold” investment strategies. However, since the onset of the ultra-low interest rates era in 2008, observers noted a decline in the credit quality of insurers’ bond portfolios. The commonly-held explanation for this deterioration is that low returns pushed insurers to become more risk-taking. We argue that other factors—such as surging rating downgrades, bond revaluations, and regulatory changes—also played a key role. We estimate that rating changes, revaluations, and search for yield each account for about one-third each of the total deterioration in credit quality. This result has important policy implications as it reestablishes the view that insurers’ investment behavior tends to be passive through the cycle—rather than risk-seeking. JEL Classification Numbers: E43, G11, G12, G22 Keywords: Life Insurance sector; financial stability; credit ratings. Author’s E-Mail Address: j.brinkhoff@dnb.nl; jsole@imf.org WORKING PAPERS Did Insurers Become Risk-Loving During “Low-for-Long”? The Role of Returns, Ratings, and Regulation Prepared by Jeroen Brinkhoff and Juan Solé1 1 We are indebted to Fabio Cortés, Pete Dattels, Matthew Jones, Fabio Natalucci, Nicola Perri, Ranjit Singh, and Nobu Sugimoto for numerous comments and suggestions on earlier drafts. All remaining errors are the responsibility of the authors. IMF WORKING PAPERS Did Insurers Become Risk-Loving During “Low-for-Long”? INTERNATIONAL MONETARY FUND 2 Contents I. Motivation ......................................................................................................................................................... 3 II. The Changing Credit Quality of Insurers’ Bond Portfolios, 2005-2021 ...................................................... 4 III. Quantification of the Portfolio Drivers ......................................................................................................... 8 IV. Data .......................................................................................................................................................... 9 V. Results ....................................................................................................................................................... 9 VI. Robustness Checks .................................................................................................................................... 12 VII. Assumption on Corporate vs. Sovereign Bonds Split ............................................................................ 12 VIII. Assumption on the Duration of Corporate and Sovereign Bonds ......................................................... 14 IX. Concluding Remarks ................................................................................................................................... 16 References ......................................................................................................................................................... 17 IMF WORKING PAPERS Did Insurers Become Risk-Loving During “Low-for-Long”? INTERNATIONAL MONETARY FUND 3 I. Motivation European policy rates were dramatically slashed in late 2008 in response to the unfolding global financial crisis of 2008-09, and then again between 2011 and 2014 on the back of the European debt crisis. The severity of these crises meant, however, that even these historically ultra-low policy rates of less than 1 percent proved insufficient to spur economic and credit growth, forcing central banks to usher in a period of unconventional monetary policies: Mos