Insurers: large global investors
Insurance companies are among the largest investors in the financial system. Collectively, they manage about USD 20 trillion worth of assets around the globe, about one-third of all investments by institutional investors. Dutch insurance firms, too, are major investors with asset holdings close to EUR 450 billion, of which a large part is invested abroad. Not surprisingly, the investment behaviour of insurance companies can affect market movements. Large-scale additional security purchases may push prices up, whereas the sale of securities may result in downward price pressure.
Investments in times of crisis
In this way, the investment behaviour of insurance firms and other large investors may also have implications for how financial crises develop. When during a crisis major investors decide to sell high-risk investments and withdraw to a safe haven, this can further exacerbate the crisis. While from an individual institution’s perspective this behaviour may be desirable with a view to reducing risks, it creates additional risks for the financial system as a whole. It is evident from previous research that mutual funds engaged in such procyclical investment behaviour in the recent crisis period. Banks were documented to have largely withdrawn to their home markets since the outbreak of the crisis in 2007, contributing to a sharp contraction in international capital flows.
Much less is known about insurance firms’ investment behaviour during financial crises. Theoretically, they are well positioned to hold on to risky investments in a crisis and retain an international investment profile. Life insurance companies in particular have a long-term investment horizon and, unlike banks and mutual funds, they are generally less vulnerable to sudden withdrawals by policyholders.
Safer and international
A recent research paper by DNB analyses the investment behaviour of Dutch insurers during the crisis, on the basis of statistics specifying each individual firm’s buying and selling behaviour of various asset classes by country. The results show that the outbreak of the European sovereign debt crisis triggered investment flows between countries. Investments in southern European euro area countries were sold and traded for investments in “safer” regions, including the Netherlands, Northern Europe and countries outside the euro area. This shift to safer investment destinations is observed mainly within the portfolio of government bonds and cannot be attributed to insurers’ investment strategies (based on momentum or country risk) that are applied equally across all countries.
In the period prior to the European debt crisis, this effect was not present. Moreover, it disappeared after ECB President Mario Draghi’s well known “whatever it takes” speech, in which he pledged that the ECB would make every effort within its mandate to preserve the euro. At no time during the crisis was there any major inflow of investments to the Netherlands relative to investments in other, relatively safe, northern European countries. The latter finding is supported by an additional analysis revealing that the preference of Dutch insurers to invest close to home (known as the home bias phenomenon) did not increase in the crisis period.
Risky government bonds
The results show that in terms of investment policy, insurers and banks responded to the crisis differently. Whereas the latter mostly focused more strongly on their home markets, insurers maintained a larger international diversification in their investment profiles. The results also indicate that in periods of intense market stress, insurers too can engage in procyclical international investment behaviour, although a certain level of stress would appear to be required for them to do so. The collapse of Lehman Brothers saw a modest increase in risk perceptions of southern European countries, without this resulting in investment portfolio shifts between countries.
A possible explanation for the observed procyclical investment behaviour is the nature of the European sovereign debt crisis, which had a strong impact on the prices of the very large government bond portfolios typically held by insurers to cover their long-term liabilities to policyholders. Based on assumed low risks, insurers hold little or no capital to absorb losses on these assets. This may have limited the possibilities for insurance companies to hold on to these investments, once substantial financial risks materialised during the sovereign debt crisis.