Variable Annuities and Systemic Risk

Abstract

This chapter argues that variable annuities may cause systemic risk in the insurance sector. Life insurers, in particular in the US, have transformed their business by moving from largely diversifiable activities to taking on market risk. This exacerbated by the fact the variable annuities are typically supplemented with guarantees. Such guarantees are effectively put-options on the stock market and expose insurers to significant stock market risk. Although insurers hedge a large fraction of the guarantees, the hedging also causes insurers to shift their asset allocation towards illiquid bonds. This backfires in the event of a correlated shock, where collective firesales of illiquid bonds result. The implications for the capital of the US life insurance sector, and systemic risk, are significant.