Do Investors Value Intermediaries’ Diversification? Evidence from Insurers’ Corporate Bond Portfolios

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Abstract:

Diversification is a core function through which financial intermediaries create value. However, do investors recognize this function? Using regulatory data on U.S. insurers’ corporate bond holdings, I document that small insurers disproportionately invest in bonds issued by financial institutions (“financial bonds”), whereas large insurers hold more diversified portfolios. Financial bonds exhibit lower idiosyncratic risk than comparable non-financial bonds, suggesting that they provide investors with intermediated diversification. Exploiting a regulatory reform in 2017 that expanded insurers’ access to bond exchange-traded funds, I show that small insurers’ demand for financial bonds declines sharply once this low-cost vehicle for direct diversification becomes accessible. Cross-sectional evidence of insurers’ financial bond investments further supports the hypothesis that insurers view financial bonds as a diversification tool. A portfolio choice model with fixed transaction costs and risk-based capital regulation rationalizes these findings. Altogether, the results indicate that insurers used financial bonds as a substitute for direct diversification prior to the reform, revealing investors’ appreciation of intermediaries’ diversification function.