Abstract
Financial intermediaries often provide guarantees that
resemble out-of-the-money put options, exposing them to
tail risk. Using the U.S. life insurance industry as a
laboratory, we present a model in which variable annuity
(VA) guarantees and associated hedging operate within
the regulatory capital framework to create incentives for
insurers to overweight illiquid bonds (“reach-for-yield”). We
then calibrate the model to insurer-level data, and show that
the VAwriting insurers’ collective allocation to illiquid bonds
exacerbates system-wide fire sales in the event of negative
asset shocks, plausibly erasing up to 20-70% of insurers’
equity capital.