The Fragility of Market Risk Insurance∗

Insurers sell retail financial products called variable annuities that package mutual funds with minimum return guarantees over long horizons. Variable annuities accounted for $1.5 trillion or 34 percent of U.S. life insurer liabilities in 2015. Sales fell and fees increased after the 2008 financial crisis as the higher valuation of existing liabilities stressed risk-based capital. Insurers also made guarantees less generous or stopped offering guarantees entirely to reduce risk exposure. We develop a supply-driven theory of insurance markets in which financial frictions and market power determine pricing, contract characteristics, and the degree of market incompleteness. (JEL G22, G28, G32) ∗A.M. Best Company, Morningstar, and the NAIC own the copyright to their respective data, which we use with permission under their license agreements with Princeton University and London Business School. This research was supported by the Julis-Rabinowitz Center for Public Policy and Finance. We thank Adam Xu and Zhen Ye for assistance on constructing data from Morningstar Annuity Intelligence. For comments and discussions, we thank Donghwa Shin and seminar participants at Boston University, Michigan State, NYU, Princeton, University of Chicago, University of Delaware, University of Michigan, and Derivatives and Volatility 2017: The State of the Art. †Stern School of Business, New York University, 44 West Fourth Street, New York, NY 10012, London Business School (on leave), NBER, and CEPR (e-mail: [email protected]). ‡Department of Economics, Princeton University, Julis Romo Rabinowitz Building, Princeton, NJ 08544, and NBER (e-mail: [email protected]).