Was the U.S. life insurance industry in danger of systemic risk by using derivative hedging prior to the 2008 financial crisis?

Abstract

This paper is an historical studyjwith implications for the presentjof the extent to which the life insurance industry contributed to systemic risk prior to the 2008 financial crisis by using derivatives to hedge product and asset risks. First, we present evidence that the life insurance industry insufficiently appreciated the risks of variable annuities with guaranteed benefits (VAGB) in the run-up to the 2008 crisis. With USD 1.6 trillion in contracts under guarantees, VAGB had become a vast and lucrative part of life insurer activities. But the guarantees expose insurers to market risk. Our analysis suggests that those risks were insufficiently hedged. Second, we assess the cumulative magnitude of all derivative risks (including VAGB risks) and find that they probably do not rise to level of a systemic threat. As part of our analysis, we introduce a new methodology for assessing the diversification of life insurers, both individually and as an industry, with respect to their counterparties (banks) in derivative hedging. We find that the life insurance industry was relatively diversified. Our contribution is three-fold: First, we demonstrate the possibility of endemic misperception of risk within a financial sector. Second, we provide a new quantitative tool to assess the potential for the contagion of risk to spread from guarantors (banks) of life insurer derivative hedges to the life insurance sector by failure of the guarantors to perform. The 2008 crisis period provides a unique laboratory to test this and other theories of risk behavior. Third, we add to the discussion of Systemically Important Financial Institutions (SIFIs).