Changes in Risk-based Capital and Reaching for Yield

The National Association of Insurance Commissioners (”NAIC”) in the U.S. proposed changes in risk-based capital (”RBC”) factors for corporate bonds in the last decade. The changes refer to a more granular structure of RBC factors, which were updated several times. I analyze the effects these revisions had on U.S. life insurers’ reaching for yield behavior. These proposed changes affect life insurers’ acquisition behavior in a period even when the old RBC factors were still applicable. I show that for examining reaching for yield, life insurers need to consider not only the downgrade probabilities but also the probability and the magnitude of an expected change in capital requirements. I find that reaching for yield is decreasing in the magnitude of the expected RBC changes. Life insurers react to the uncertainty of RBC changes and adjust their investment decisions when the proposed RBC factors are near the implementation date. Modifying RBC bond factors to enhance the identification of potentially weakly capitalized companies represents a positive and progressive step forward.