Can Financial Institutions Act As Asset Insulators?
Gabriel Chodorow-Reich
University of California, Berkeley – Department of Economics
Andra C. Ghent
University of Wisconsin – School of Business – Department of Real Estate and Urban Land Economics
Valentin Haddad
Princeton University – Bendheim Center for Finance
May 28, 2016
Abstract:
We propose that financial institutions can act as asset insulators, holding assets for the long run to protect their valuations from consequences of exposure to financial markets. We illustrate the empirical relevance of this theory for the balance sheet behavior of a large class of intermediaries, life insurance companies. The pass-through from assets to equity is an especially informative metric for distinguishing the asset insulator theory from Modigliani-Miller or other standard models. We estimate the pass-through using security-level data on insurers’ holdings matched to corporate bond returns. Uniquely consistent with the insulator view, outside of the 2008-2009 crisis insurers lose as little as 10 cents in response to a dollar drop in asset values, while during the crisis the pass-through rises to roughly 1. The rise in pass-through highlights the fragility of insulation exactly when it is most valuable.
Can Financial Institutions Act As Asset Insulators?- Introduction
Financial intermediaries such as banks, life insurers, and pension funds hold tens of trillions of dollars of securities. Does the organization of ownership of financial assets matter? A long tradition tracing to Modigliani and Miller (1958) says no. Yet, a debate has erupted on the role of these institutions and whether alternative structures of the financial sector would affect the provision of financial intermediation. Addressing these issues requires understanding why these institutions exist and how they create value for their stakeholders, if at all.
In this paper, we propose that some financial intermediaries act as asset insulators. An asset insulator holds assets for the long run, protecting asset valuations from consequences of exposure to financial markets. This activity is the source of value creation and shapes the evolution of the intermediary’s market equity. Viewing financial institutions as insulators makes prescriptions for their portfolio choice, liability structure, and trading behavior. To discriminate asset insulation from alternative theories of intermediation, we introduce the asset pass-through: the change in market equity in response to a dollar change in the market value of assets. For an insulator, the pass-through is typically below one, reflecting the insensitivity to some market fluctuations, but rises in periods of financial distress as the deterioration in the financial health of the intermediary threatens its ability to act as a long-lived investor.
We illustrate the empirical relevance of this theory in the context of a large class of intermediaries, the life insurance sector. The balance sheets of life insurers exemplify an asset insulation strategy. Insurers hold illiquid and risky assets for long intervals, an asset allocation that is complementary to their having relatively stable liabilities. This pattern is at odds with the common view of insurers making portfolio choices primarily to offset the interest rate risk of their policy liabilities. We then construct a data set of detailed regulatory data on insurers’ security-level holdings matched with returns on those securities to measure the pass-through. A one dollar drop in asset values outside of the 2008-09 financial crisis results in a decline in equity of as little as 10 cents, while during the crisis the pass-through rises to approximately 1, uniquely consistent with the insulator view. Finally, the importance of asset insulation rises during the financial crisis, accounting for an increase in the franchise value of insurers of tens of billions of dollars.
We start our analysis by providing a model of an asset insulator. The model has two key ingredients. First, the value of assets on traded markets is affected by shocks that do not affect value if held inside the intermediary. We review a number of motivations for such a wedge. Second, because of leverage, the financial intermediary will have to liquidate its holdings on the open market if the value of assets deteriorates beyond a certain threshold. We solve the model to obtain an analytic expression for the firm’s market equity. The wedge between the value of an asset held inside the firm and on the open market means that the Modigliani-Miller theorem does not apply in our setting. We define franchise value as the difference between the firm’s market equity and the market value of financial assets minus liabilities. The franchise value fluctuates in response to both changes in the value of the asset insulation function and the ability of intermediaries to perform it.
Life insurers are a natural candidate to provide asset insulation. Life insurance and annuity policies have long contractual horizons. While policyholders may have the option to take an early surrender, the quantity of surrenders does not spike during periods of financial turmoil such as during the financial crisis. Thus, the long and predictable duration of liabilities makes insurers natural holders of assets which have transitory fluctuations in market prices. Our analysis of life insurers also takes advantage of the availability of detailed, security-level regulatory data.
Insulators should target assets which have a large wedge between their valuation on and off the market. Illiquid, risky assets provide such an opportunity. Indeed, Treasuries and agency bonds constitute only about 13% of insurers’ assets, and the other assets on their balance sheet are not Treasury-like in their risk characteristics. The largest concentration of holdings is in corporate bonds. Even before the crisis in 2006, roughly half of these corporate bonds had a rating of BBB or below. Insurers hold securities for an average length of four years, a horizon long enough to allow the transitory fluctuations in market prices to dissipate. The portfolio concentration in illiquid, risky assets sharply contradicts the commonly held view that life insurance companies choose their assets solely to neutralize the interest rate risk of their liabilities (see, e.g., Briys and De Varenne, 1997).
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