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In this paper, we explore U.S. life insurers’ exposure to mortgage backed securities (MBS) and its potential impact on capital should the credit ratings of these bonds be lowered. We analyse 2 years: 2003 (well before the realisation of problems with these instruments) and 2006 (immediately prior). We create five potential scenarios of different severity for recategorising MBS credit ratings and compute the theoretical impact on measured insurer asset risk, via a proxy for the C-1 component of life insurers’ risk-based capital. Under all scenarios, we find large increases in assessed asset risk. We then model insurer capital structure as a function of asset risk and other factors to assess whether insurers had prepared their capital structures for the possibility of problems with these instruments. Our findings indicate not only that insurers were unprepared for MBS downgrades, but also that they reduced capital as they accumulated MBS, as though acquiring MBS should raise the overall quality of the investment portfolio. Finally, we analyse possible adjustments to capital to accommodate the now recognised increased risks of MBS. Our models suggest, for example, that an insurer with median residential MBS exposure might be expected to increase its capital by 10 per cent or more to maintain a historical relationship between capital and risk factors, in the event of a moderate recategorisation of MBS risk. Even larger adjustments are indicated should the crisis spread to commercial MBS as well. The Geneva Papers (2009) 34, 100–118. doi:10.1057/gpp.2008.40

The Impact of Mortgage-Backed Securities on Capital Requirements of Life Insurers in the Financial Crisis of 2007–2008