The importance of managerial decisions related to interest-sensitive cash flows has received considerable attention in the insurance literature. Consistent with the interest-sensitive nature of insurer assets and liabilities, empirical research has shown that insurer insolvency is significantly related to interest rate volatility. We investigate the interest rate sensitivity of monthly stock returns of life insurers based on a generalized autoregressive conditionally heteroskedastic in the mean (GARCH-M) model. We examine three different portfolios (equally weighted, risk-based, and size-based) with binary variables to explicitly account for varying interest rate strategies adopted by the Federal Reserve System. Results based on data for the period 1975 through 2000 indicate that life insurer equity values are sensitive to long-term interest rates and that interest sensitivity varies across subperiods and across riskbased and size-based portfolios. The results complement insolvency research that links insurer financial performance to changes in interest rates.Elijah Brewer III is at Federal Reserve Bank of Chicago, Chicago, IL 60604-1413; James M. Carson is at . The authors thank the editor, two anonymous referees, James Doran, participants at meetings of SRIA and SFA, and seminar participants at the University of Georgia and the University of Iowa for constructive comments and helpful suggestions that improved the quality of the article. The views expressed here are those of the authors and do not represent the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of Chicago.
INTEREST RATE RISK AND EQUITY VALUES 403financial institutions. We then describe our sample, data, and methodology. Next we analyze the empirical results, and the final section summarizes and concludes.
REVIEW OF RELATED LITERATUREInsurers issue stochastic debt instruments for which the amount and timing of loss payments (contingent claims) are unknown at policy issuance, and they invest the proceeds to maximize the risk-adjusted return on capital. By effectively "borrowing" from policy owners, insurers lever ownership capital. Interest rate risk, defined as the degree of exposure, or elasticity, of insurer net worth to changes in the interest rate, is important to life insurers for a number of reasons, as discussed, e.g., by Staking and Babbel (1995) and Briys and Varenne (1997). The importance of interest rate risk is based on (1) the investment portfolio of the typical highly leveraged insurer is concentrated in long-term fixed-income securities; (2) life insurer performance is negatively related to changes in interest rates Hoyt, 1999, 2001);(3) for insurers whose duration of assets exceeds that of their liabilities, rising interest rates erode the value of surplus, leading to increased leverage and a greater probability of ruin; (4) higher leverage increases the insurer's cost of capital (Cummins and Lamm-Tennant, 1994); and (5) interest rate risk leads insurers to take steps to match asset-liability durations ...
