Where do the insurance companies invest?

Insurance companies perform one of the most important forms of financial intermediation in modern society. Specifically, they allow households to share risk and protect themselves against the economic costs of accidents and injuries that would otherwise have devastating effects on peoples' lives and savings. A less known side of insurance companies is that they are also major investors in financial assets. Given that insurance companies receive insurance premia immediately and only pay out in case of an accident later on, underwriting an insurance contract involves an investment decision: what should the insurance company do with money it receives for underwriting insurance contracts? In our paper, we investigate how the particular funding structure of insurance companies – the underwriting of insurance contracts – makes them ideal investors in illiquid corporate bonds. Further, we document how insurance companies' investment strategies affect the price of insurance contracts faced by everyday consumers.

To understand the paper's main insights, let's discuss three key features of the insurance business. First, insurance companies underwrite many similar contracts in order to diversify their insurance portfolios. Diversification makes the aggregate cash flows generated by insurance underwriting predictable; we don't know what specific house will catch fire, but the insurance company has a pretty good idea of the fraction of houses that will burn in a given year and how much they will have to pay to policy holders to fix damages. A second feature is that insurance demand is relatively stable; people tend to buy house insurance and car insurance in good times and bad times indifferently. This provides insurance companies with a stable source of funding which is less sensitive to market fluctuations than funding structures of other investors (e.g. mutual funds or banks). These first two features of the insurance business make insurance underwriting a stable and predictable source of funding for insurance companies.

The question is then what the insurance companies should invest in given their funding structure and the answer turns out to be illiquid bonds (Empirically we find that illiquid credit makes up more than 70% of US Life Insurers' investment portfolios). Illiquid bonds are debt securities which can be hard to sell and therefore trade at a discount relative to their fundamental values. If you are an investor whose funding dries up when the market goes down, you don't want to hold too many illiquid assets as you could be forced to sell them at a big discount. This is a well-known issue for open-end mutual funds and even banks that are vulnerable to so-called runs (hello, Silicon Valley Bank), but if you have stable funding you have an advantage. You can buy illiquid, but fundamentally sound, assets at a discount because you can commit holding these assets until maturity due to the stable nature of your funding; policy holders cannot claim their money back at will and houses won't start catching on fire more than usual just because there is turmoil in bond markets. This means insurance companies, because of their stable funding, have higher expected returns on illiquid assets than other investors.

The third and final feature of the insurance industry is that it is competitive. Because insurance underwriting is a valuable source of funding, insurance companies compete to attract customers by setting lower prices. This means that part of the excess return that insurance companies can make by investing in illiquid bonds is being passed on to policy holders through lower insurance prices. We denote this mechanism asset-driven insurance pricing and document its presence across different insurance products and time periods.
In summary, we argue that insurance companies use their stable funding to earn excess returns on illiquid assets and pass back part of these excess returns to policy holders who are the source of stable funding. This implies that insurance premiums are lower when insurance companies have higher than expected investment returns because insurers compete for funding. In this way, insurance companies combine two very valuable forms of financial intermediation by buying assets when other investors are forced to sell, and by enabling risk-sharing amongst households and corporations at competitive prices.