1. 1 How Does Background Risk Affect Investment Risk-taking? Evidence from Insurers’ Corporate Bond Portfolios Xuanjuan Chen, University of North Carolina Tong Yao, University of Arizona Tong Yu, University of Rhode Island IIS 2006, Chicago

2. 2 Bond Portfolio of an Average P&L Insurer

3. 3 Questions Do insurance companies hold and trade on corporate bonds in response to background risks from their underwriting business? Any effect of an insurer’s performance and loss experience on the interaction between background risk and bond investment? Do financing constraints Matter?

4. 4 Major Findings Insurers with greater background risk take less risky bond portfolios Corporate bond investment risk of poorly- performing insurers is positively correlated with background risk The effect of background risk is stronger for insurers with higher financing constraints.

5. 5 Background Risk Literature Theoretical General framework: Pratt (1964), Pratt and Zeckhauser (1987), Kimball (1993), Gollier and Pratt (1996) Labor income risk: Bodie, Merton and Samuelson (1992), Koo (1998), Heaton and Lucas (2000c) Housing risk: Cocco (2004), Yao and Zhang (2005) Empirics Labor income risk: Guiso, Jappelli and Terilizzesse (1996), Heaton and Lucas (2000b), Angerer and Lam (2006) Housing risk: Yao and Zhang (2005)

6. 6 Other Literature and Major Hypothesis Other insurance related studies –Badrinath, Kale and Ryan (1996) –Baranoff and Sager (2002) –Yu, Lin, Oppenheimer and Chen (2005) Major Hypothesis –There is a negative relationship between bond risk taking and background risk

7. 7 Data Fixed Investment Securities Database (FISD) NAIC Schedule D data NAIC data A.M. Best

8. 8 Bond Portfolio Risk Measures Bond Characteristics –Rating –Duration –Yield Holding-based risk measures Trading-based risk measures

9. 9 Measuring Background Risk Asset book value Loss volatility Length of an insurer’s claim tails Level of competition Herfindahl index Best’s rating Policyholder surplus to total assets

10. 10 Effect of Background Risk on Holding Risk Measures (Univariate Analysis) (Table 4.A)

11. 11 Effect of Background Risk on Holding Risk Measures (Multivariate Analysis) (Table 4.B)

12. 12 Effect of Background Risk on Trading Risk Measures (Univariate Analysis) (Table 5.A)

13. 13 Effect of Background Risk on Trading Risk Measures (Multivariate Analysis) (Table 5.B)

14. 14 Gambling Incentives Hypothesis: The gambling incentive of insurers with relatively poorer performance and worse performance reduce the effect of background risk on bond investment Classifying Insurers into Performance Groups –Standardized unexpected losses –ROA

15. 15 Effect of Gambling on Bond Holding (Table 6.A)

16. 16 The Effect of Gambling on Bond Trading (Table 7.A)

17. 17 Financing Constraints Hypothesis: an insurer’s is more sensitive to their background risk when facing financing constraint –E.g., Fazzari, Hubbard and Petersen (1988, 2000) Measure of financing constraint –Mutual versus Stocks – effect is not strong –Affiliated versus Non-affiliated – strong effect

18. 18 Effect of Financial Constraints on Bond Holding (Table 8.B)

19. 19 Effect of Financial Constraints on Bond Trading (Table 9B)

20. 20 Implications Asset and liability management of insurance companies Asset management of institutional investors in general