The Determinants and Potential Effects of Life Insurer Mortgage Backed Securities Exposure

Our study examines two aspects of life insurers’ exposure to the troubled residential mortgage backed securities (RMBS) market. First, we develop and estimate a model that explains cross-sectional variation in RMBS exposure in terms of firm characteristics. We find that firms least likely to invest in RMBS tend to be small and to have high separate accounts ownership and large investments in common stocks and cash and short-term investments. Among firms that do invest in RMBS, publicly traded firms and those with a relatively high proportion of separate accounts assets have lower levels of RMBS exposure. We then estimate the effect of a change in RMBS risk ratings on insurer surplus via the asset valuation reserve. We find that, while there is a measurable exposure to RMBS, this exposure and its resulting effects on the asset valuation reserve are unlikely to have a major impact on most insurers’ balance sheets. However, a dramatic downgrade of aggregate (residential plus commercial) mortgage backed securities could result in a decrease in surplus of almost 10% for the largest U.S. life insurers.