On the Demand for Portfolio Insurance

• Published date: 01 September 2013
• Date: 01 September 2013
• Author: James M. Carson,Andy Fodor,James S. Doran,David P. Kirch
• DOI: http://doi.org/10.1111/rmir.12009

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2013, Vol.16, No. 2, 167-193

DOI: 10.1111/rmir.12009

FEATURE ARTICLES

ONTHEDEMAND FOR PORTFOLIO INSURANCE

Andy Fodor

James S. Doran

James M. Carson

David P. Kirch

ABSTRACT

While insurers manage underwriting risk with various methods including rein-

surance, insurers increasinglymanage asset risk with options, futures, and other

derivatives. Previous researchshows that buyers of portfolio insurance pay con-

siderably for downside protection. We add to this literature by providing the

first evidence on the cost of portfolio insurance, the payoff to portfolio insur-

ance, and the relative demand for portfolio insurance across VIX levels. Wefind

that the demand for portfolio insurance is relatively high at low levels of VIX,

suggesting purchasers demand more downside protection when this protec-

tion is cheap on an absolute basis (but expensive on a relative basis). We also

provide the first evidence on the hedging behavior of specific investor classes

and show that the demand for portfolio insurance is driven by retail investors

(individuals) who buy costly insurance from institutional investors. Results are

consistent with other types of paradoxical insurance-buying behavior.

INTRODUCTION

Portfolio insurance is an important risk management tool for individuals, firms, and pro-

prietary traders. While insurers use reinsurance to manage underwriting risk, insurers

increasingly use options, futures, and other derivatives to manage asset risk (see, e.g.,

Nye and Kolb, 1986; Hoyt, 1989; Colquitt and Hoyt, 1997; Cummins et al., 1997, 2001).

Insurers’ motivation to hedge asset risk is further heightened by regulatory pressure

(Cummins, 2000) and customer sensitivity to insolvency risk (Merton and Perold, 1993;

Epermanis and Harrington, 2006), and perhaps most notably by the financial crisis that

began to unfold in 2007–2008.

Andy Fodor is Department Chair at the Department of Finance, Ohio University, Columbus,

OH 43210. James S. Doran is Portfolio Manager at Implied Capital LP,Boulder, CO 80302. James

M. Carson is the Daniel P. Amos Distinguished Professor of Insurance at the Department of

Insurance, Legal Studies, and Real Estate, Terry College of Business, University of Georgia,

Athens, GA 30602-6255; phone: (706) 542-3803; fax: (706) 542-4295; e-mail: jcarson@uga.edu.

David P. Kirch is at the School of Accountancy, Ohio University, Columbus, OH. The authors

thank two anonymous reviewers and the Editor for helpful comments. This article was subject

to double-blind peer review.

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168 RISK MANAGEMENT AND INSURANCE REVIEW

FIGURE 1

Annualized Standard Deviation of Daily S&P 500 Returns and the Change in VIX

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

S&P 500 Vix

Note: The figure presents annualized returns for the S&P 500 and the change in the VIX index

each year from 1991 to 2010. The correlation between the S&P 500 and the VIX index is –0.56.

Because U.S. insurers hold a substantial dollar amount of their investment portfolio

in equities, increased levels of equity market volatility, as shown in Figure 1, which

coincide with negative or low equity returns, suggest that insurer interest in managing

asset portfolio exposure is important and likely to continue to rise. At the same time, it is

well known that buyers of portfolio insurance pay a significant premium for downside

protection (Bates, 2000; Doran and Ronn, 2005).1While we note the particular motivation

and interest of insurers for using portfolio insurance, the paper’s analysis and findings

also are applicable in a broader sense.

In this article, we provide new insights on the relationships between hedging behavior

and market-implied volatilities as measured by the VIX, a measure of expected stock

market volatility. Prior literature has not examined the shape of the portfolio insurance

cost curve across levels of VIX (e.g., concave, convex) or whether the payoffs to portfolio

1Bollen and Whaley (2004) show that index put option buying pressure of hedgers drives the

shape of the implied volatility function, contributing to its downward slope. The negative rela-

tionship between VIX and equity returns and the more general negative volatility risk premium

has been widely documented (e.g., Jackwerth and Rubinstein, 1996; Coval and Shumway,2001;

Bakshi and Kapadia, 2003; Giot, 2005; Banerjee et al., 2007).