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. © The Journal of Risk and Insurance, 2007.