|
|
Hence, higher interest rates raise surrender rates, as we document empirically by exploiting plausibly exogenous variation in monetary policy. Using a calibrated model, we then estimate that surrender options would force insurers to sell up to 2% of their investments during an enduring interest rate rise of 25 bps per year. We show that these fire sales are fueled by surrender value guarantees and insurers’ long-term investments. To mitigate surrender-driven risks in the life insurance sector, we propose the use of market value adjustments that adjust surrender payouts to interest rate changes.
Life insurers are significant financial intermediaries, as they hold 20% of outstanding bonds (IMF, 2021) and their products account for more than 20% of households’ assets.1 An important role of life insurers is to facilitate household saving by offering long-term savings contracts. These contracts typically entail surrender options, which allow policyholders to terminate a contract before its maturity and receive an ex-ante guaranteed redemption value, termed surrender value.
Policymakers have only recently started to consider the liquidity risk driven by surrender options, sparked by the (risk of) rising interest rates (e.g., ECB, 2017; EIOPA, 2019; NAIC, 2021).2,3 For example, in early 2023, the Italian life insurer Eurovita was placed under special administration and its surrender payouts were halted by the regulator as rising interest rates amplified the risk of high surrender rates (Fitch Wire, 2023). Despite policymakers’ increasing awareness, research on liquidity risk in life insurance is still scarce.
Three motivating facts emphasize the importance of surrender-driven liquidity risk. First, surrender payouts are economically significant. European life insurers paid out EUR 362 billion for surrendered contracts in 2019, which corresponds to more than 40% of their premium income. Second, insurers are important investors. For instance, in euro-area debt markets, insurers account for roughly 20% of outstanding government and corporate bonds (ECB, 2022). Given the importance of bond prices for economic activity (Gilchrist and Zakrajšek, 2012; Kubitza, 2023), it is important to understand the determinants of insurers’ investment behavior. In the most extreme case that European insurers financed the surrender payouts of 2019 entirely by selling assets, the associated price impact would be in the order of 3.6% (= 362/10 000), assuming that prices decline by 10 bps per EUR 10 billion of assets sold as in Greenwood et al. (2015). Thus, surrender-driven asset sales have the potential to significantly impact financial markets and, thereby, financial stability. Third, past historical episodes provide anecdotal evidence that interest rate hikes impair life insurers’ liquidity (Kubitza et al., 2023). Nonetheless, little is known about the impact of surrenders on life insurers’ liquidity risk and asset sales across the financial cycle...
more at SUERF