Insurance companies are important investors in the bond market. According to the 2004 Best Aggregate and Average Reports, insurance companies on average invest over 55 percent of their total assets in bonds. Their role in the corporate bond sector is especially prominent. According to the Federal Reserve's Flow of Funds accounts (fourth Quarter, 2000), insurance companies hold about one-third of outstanding corporate bonds in the late 1990s.
One may attribute insurers' heavy investments in bonds to regulatory reasons, such as the influence of the Prudent Man regulations and the Model Investment law. However, regulatory reasons cannot explain the substantial difference present in the risk-taking behavior across insurers' corporate bond portfolios. For example, in our data sample, we observe that some firms solely invest in high-quality, investment grade corporate bonds, while others aggressively invest in speculative-grade bonds.
In this paper, we study how background risk affects the risk-taking behavior of insurance firms in their corporate bond investments. Economic theories, such as Pratt (1964), Pratt and Zeckhauser (1987), Kimball (1993), Gollier and Pratt (1996), Eekhoudt, Gollier, and Schlesinger (1996), and Heaton and Lucas (2000a) suggest that investors facing greater background risks, i.e., risks beyond their control, may behave as if they were more risk averse, preferring safer assets.
For insurance companies, when they make portfolio investment decisions, background risk stems from their underwriting business, and the uncertainty in insurance claims. Risks from in insurers' business operations are typically not tradable and difficult to smooth away by other means. They are also beyond the control of portfolio managers, and therefore can be viewed as a type of background risk for insurers portfolio investments.
