Interest Rate Risk and Equity Values of Life Insurance Companies: A GARCH-M Model

ABSTRACT 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 risk-based and size-based portfolios. The results complement insolvency research that links insurer financial performance to changes in interest rates. INTRODUCTION Interest rate risk is an important concern for financial firms, and a large body of literature shows a strong relation between the stock returns of financial institutions and interest rates. Much research has investigated the interest sensitivity of commercial bank equity returns (e.g., Lloyd and Shick, 1977; Lynge and Zumwalt, 1980; Chance and Lane, 1980; Flannery and James, 1984; Bae, 1990; Kwan, 1991; Scott and Peterson, 1986; Kane and Unal, 1988, 1990; Elyasiani and Mansur, 1998, 2003). However, excepting the early works of Scott and Peterson (1986) and Bae (1990), little attention has been paid to the interest sensitivity of life insurer equity returns. Santomero and Babbel (1997) state that insurers have a sense of urgency to apply the tools of asset/liability management to manage interest rate risk. Life insurer equity returns that vary with changes in interest rates suggest that the market is accounting for their interest rate exposure. Thus, we investigate the interest rate sensitivities of monthly stock returns of life insurers. We make four primary contributions. First, we evaluate the systematic factors that generate life insurer common stock returns by utilizing a GARCH-M (generalized autoregressive conditionally heteroskedastic in the mean) model. The model includes several basic capital asset pricing models as its special cases and allows a test of their validity. Although previous research has employed the GARCH-M methodology (Elyasiani and Mansur, 1998) in the analysis of the interest rate sensitivity of depository institution stock returns, to our knowledge the current study is the first application of a GARCH-M model in the analysis of the interest rate sensitivity of life insurer stock returns. Second, the study tests if the interest rate sensitivity of life insurers stock returns and overall stock return volatility of these firms remain constant over time, when the Fed adopts different interest rate strategies, and interest rate volatility changes as a result. Third, the study employs a comprehensive data set for the period from 1975 through 2000. Finally, to examine firm level variation in interest rate sensitivity, the sample is disaggregated and portfolios are formed based on high-beta and low-beta firms as well as small, medium, and large insurers. (1) Our results provide several insights. First, consistent with research on insurer financial strength (e.g., Browne, Carson, and Hoyt, 1999), we find the equity values of life insurers to be sensitive to long-term interest rates. Second, as in previous studies for depository institutions (e.g., Scott and Peterson, 1986), the stock returns of life insurers are negatively related to changes in interest rates. Third, similar to studies for other financial institutions (e.g., Yourougou, 1990), we find that the interest rate sensitivity of life insurer stock returns varies across the monetary policy regimes. …