How Does Hedging Affect Product Market Competition?

Professor of Finance and Michael J. Falcone Chair in Real Estate Erasmo Giambona and colleagues examine this question in an article in the Review of Financial Studies. They find that if life insurance companies have the opportunity to better protect their assets, they can price their products more competitively. This in turn allows them to gain market share and serve customers more effectively.

Giambona—with Anil Kumar, associate professor of finance and real estate at Aarhus University in Denmark, and Gordon Phillips, the Laurence F. Whittemore Professor of Business Administration at Dartmouth College—
took advantage of a natural experiment unfolding in the life insurance sector. With over $7 trillion in assets and over 1,000 private and public firms, it is one of the largest industries in the United States.

Since 1998, 22 states have introduced legislation that lowers the cost of hedging for insurance firms. It does this by allowing derivatives counterparties—organizations willing to assume risk for the companies for a price—to more easily repossess collateral in case of financial distress.

“We exploit the fact that this regulation was passed in different states at different points in time, and it affected companies based on their domicile state,” Giambona says. As similar companies competed for the same
customers in a marketplace, some benefited from the new legislation, based on their home state, while the other did not. “This is really beautiful from a research point of view,” Giambona says. “It’s quite similar to medical research.
Using the staggered difference-indifference methodology, we could make a direct comparison between one entity getting the treatment and the other having a placebo."

Assured that their assets would be better protected from potential losses, insurers in states that had passed the regulation could offer better pricing for their life insurance policies and annuities. As a result, these firms outpaced
their competitors.

In practice, Giambona said, these findings indicate that properly tailored financial innovation can be helpful for the stability of both a particular sector—in this case, life insurance—and the wider economy. “If this industry went
belly-up, it could potentially bring the U.S. or world economy down,” he says. More consumers benefit as they gain access to better and cheaper products from more companies.

Giambona, E. (2024), Hedging, Contract Enforceability, and Competition
(with Kumar, A. and Phillips, G.) Review of Financial Studies.