Market Crash Risk and Implied Volatility Skewness: Evidence and Implications for Insurer Investments

Abstract

Insurers in the U.S. hold over $5 trillion in assets, with approximately $1 trillion of these assets held in equities. While insurers manage underwriting risk with reinsurance, insurers increasingly manage asset risk with options, futures, and other derivatives. We demonstrate, using all options on the S&P 100 from 1996-2002, that 1) the shape of the implied volatility skew has statistically and economically significant forecast power for assessing the degree of market crash risk, 2) implied volatility skew coefficients are significant and consistent with market crash hypotheses, 3) the cost of hedging with put options (crash insurance) varies directly with the probability of market crash, and 4) hedging is least (most) likely to be cost-effective during bull (bear) markets and when the probability of a market crash is below (above) specified threshold levels. Findings are consistent with investor aversion to large losses, and the evidence suggests that a dynamic hedging program dominates continuous hedging for maintaining insurer financial strength.