Tackling the question of insurance companies and pension plans in systemic risk

The Bank of England has published a useful discussion paper on insurance companies and pension plans as procyclical investors. This important topic is one of the few that has not gotten significant attention since the financial crisis. Sure, its all well that banks have higher capital requirements. But what happens if the major investors all rush towards an exit at the same time? The market will crash, that’s what, with ramifications for a wide variety of financial market participants.

The report, “Procyclicality and structural trends in investment allocation by insurance companies and pension funds,” is a product of the Bank of England and the Procyclicality Working Group, which includes a number of academics and industry participants. The focus of the paper is to explore the issues – this is not a recipe book for solutions quite yet. According to the authors, “The paper largely considers procyclicality in terms of shifts in asset allocation between asset classes, for example between what are considered to be higher-risk to lower-risk asset classes (e.g. from equity to fixed income). But procyclicality could also be evident in shifts in allocation within asset classes, for example from higher-risk to lower-risk bonds (e.g. from low-rated corporate bonds to high- rated government bonds).”

To no great surprise, the paper finds procyclical investing trends at life insurance companies: “We find some evidence of procyclical investment behaviour by insurance companies both internationally and in the UK. In the UK, there is some evidence of procyclical shifts in asset allocation following the dotcom crash of the early 2000s, and to a lesser extent during the recent financial crisis.” However, the paper lacks data on derivatives, which we think are becoming more than ever a focal point for potential procyclical market investments, particularly if there is more liquidity in the derivative than in the underlying. This is an important point that should be covered by academics elsewhere.

Pension plans show more of a mixed outcome: “While pension funds in some countries appear to have behaved countercyclically during 2008–09, engaging in large net equity purchases as markets fell, others engaged in net sales of equity during the crisis. This arguably reflected structural shifts in these countries towards more conservative asset allocations, rather than being a reaction to market conditions, but nonetheless may have been destabilising in the context of market developments at that time.” There are no great conclusions to be drawn here.

Most interesting to us is the clear correlation between regulatory change and large investor “herding” behavior. The paper points out one instance (and we can think of more) of a specific regulatory change that resulted in a specific asset allocation change. “An example of this is given by the strong movement of pension funds into index-linked gilts in the mid-1990s, following changes to pension fund regulation, which exerted considerable downward pressure on the yields on these securities.” The paper notes the somewhat random or delayed nature of regulations that may create procyclical movements by investors rather than limit them.

As the authors promised, there are no firm answers in this discussion paper. Rather, the paper serves to generate content and discussion on the important topic of insurance companies and pension plans as major market movers and perhaps a source of systemic risk. We look forward to more work on this topic.

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