SESSION VII - International portfolio frictions

ABSTRACT: We study the asset allocation decisions of European life insurance companies across domestic and foreign fixed income markets using new data from regulatory Solvency II filings. While life insurers allocate the majority of their assets abroad, the characteristics of domestic financial markets still dictate insurers' portfolio allocation along two dimensions. First, the size of domestic corporate bond markets relative to overall fixed income markets is strongly positively correlated with insurers' overall fixed income allocations. Second, the interest rate earned on their fixed income portfolio is strongly positively correlated with the level of domestic government bond yields. Our findings cannot be explained by traditional international portfolio frictions such as home country bias and home currency bias, and we provide evidence for two new salient frictions. First, insurers do not offset (and if anything amplify) the tilt inherited from the structure of domestic fixed income markets, which we label foreign portfolio disconnect. Second, multinational insurance groups act like domestic insurers when operating a subsidiary in another country, which we label imported home bias. We then explore how differences in credit risk assumed on insurers' balance sheets lead to (i) a more fragile insurance sector, (ii) lower leverage or (iii) insurance products that move the credit risk to the balance sheets of households. We conclude by discussing the importance of our findings for the transmission of monetary policy to insurance companies' balance sheets and broader capital market integration.