Investment Transparency Encourages Copycats—and Creates Risks

In the United States insurance industry, transparency rules create a copycat’s paradise. Regulators require insurers to disclose not only their investment holdings, but their security-level transactions—more detail than even banks must provide.

These open portfolios are meant to protect consumers by encouraging prudent investing and capital preservation at insurance companies. But Tom Hagenberg, an assistant professor of accounting information and management at the Kellogg School, finds that this high level of transparency encourages investment mimicry and herding, which can create unintended consequences for the entire financial system.

When insurance companies so readily copy each other’s investment strategies, it can benefit their short-term financial goals, but it comes at the cost of greater systemic risk, Hagenberg says.

“While it appears like there is low idiosyncratic risk at each individual firm, there might be this buildup of collective risk because everybody’s essentially holding the same assets,” he says. “Then when there’s some sort of capital constraint, like a financial crisis, and they all need to go flood the market for capital, the prices will spiral.”

An increase in transparency

While insurance companies are nominally in the business of underwriting policies, the bulk of their profits come from their investments. When policy payments come in, that capital is used to purchase securities, similarly to how a bank reinvests its customers’ deposits. As a result, insurance companies are some of the world’s largest institutional investors, with roughly $8 trillion in collective holdings as of 2022.

Regulators subject insurers to intense scrutiny to make sure that these companies don’t take on excessive risk and maintain sufficient liquidity to pay out their claims. In the U.S., the National Association of Insurance Commissioners mandates that insurers file annual reports of holdings and quarterly reports of transactions.

The strict oversight and granular data are intended to prevent a loophole called intra-period risk, where companies make risky moves between required disclosures.

“There’s this concept in the insurance industry called reaching for yield, where they’ll take on excess risk to try to maximize profits,” Hagenberg said. “If you can’t see what they’re doing in the in the middle of the year, they can just clean that up for year-end.”

Sharing these market moves with regulators also opens up insurers’ portfolios to the public. But until recently, the information was buried in technical filings where only the most determined consumer or competitor could extract them.

That changed in 2013 when a market data provider began to aggregate the filings electronically. Now, a subscriber can click on any insurance firm and see their holdings as of the most recent quarter, making it easy for insurers to sneak a peek at their peers’ investments.

Follow the leader

Hagenberg used that sudden expansion in data availability to investigate how often insurance firms mimic each other’s investment strategies. By reconstructing each company’s portfolio at the end of every quarter from 2011 to 2014, he could test whether the launch of the new data service in 2013 increased the similarity of those holdings.

His analysis found that it did; the average insurer portfolio more closely resembled its peers’ investments in the quarters after the data became more accessible.

Hagenberg also found that smaller, less-sophisticated insurers were more likely to mimic the investments of other firms, with the most dramatic increase in similarity. Conversely, firms that displayed higher investment returns in the previous quarter were most likely to be copied.

By contrast, Hagenberg found no change in portfolio similarity among a sample of U.S. banks—which do not have to disclose individual security holdings—during the same period.

The results track with a scenario where smaller companies, which may only have one or two investment managers on staff, look to replicate the strategies of industry giants and their robust investment teams. Increasing profits may be one motive, but Hagenberg says smaller insurers may also be looking for investments that push the boundaries of risk yet have, so far, avoided attracting the scrutiny of regulators.

At the level of individual firms, this mimicry may not do much harm to either side. Smaller companies can piggyback on the research and strategies of larger, more-sophisticated insurers that reap the benefits of others buying into their security holdings.

“If [a big insurer like] Allstate has high returns in this quarter, then the next quarter, other firms are going to pick those securities that they held,” Hagenberg says. “So, I don’t think the big companies are necessarily suffering, because they’re into their investments in advance of the followers getting into those positions.”

The pitfalls of herding

Instead, the risk of this copycat behavior may fall more broadly across the entire financial system. With more insurers holding the same securities, a sudden crash in one or more of those holdings could quickly spread damage across the entire insurance industry. And as the 2008 financial crisis demonstrated, that could cause massive problems globally.

At that time, the insurance company AIG was considered “too big to fail.” But when it did face collapse, the Federal Reserve Bank of New York bailed it out because its connections with other economic players would have otherwise sparked a disastrous domino effect. Today, widespread portfolio similarity could amplify that danger, Hagenberg says.

“If companies are holding all the same investments that AIG does, and AIG suddenly has a huge capital requirement where they need to unload all of their securities, that’s going to have this systemic effect across all of the firms that hold similar securities,” he says.

Using a measure of systemic risk, Hagenberg determined that the companies more likely to mimic their peers’ investments were also more sensitive to financial distress. Those that exhibited a significant increase in portfolio similarity during the years studied showed a 7.5 percent increase in expected capital erosion during an economic downturn, reflecting additional vulnerability in a crisis.

The research not only highlights an understudied point of weakness in the financial system, but also an important trade-off in regulatory policy. While increased transparency can prevent individual insurance companies from making careless investments with their customers’ money, those detailed disclosures come at a cost, potentially elevating other threats.

“Prudential market regulation should consider unintended or alternative effects,” Hagenberg says. “Transparency that is seeking to manage idiosyncratic risk can lead to collective risks, and that’s very unintuitive. Does it mean you get rid of that level of transparency? Of course not. It’s just one potential consequence of that requirement.”