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Qianlong Liu's Abstract

To hedge interest rate risk on the balance sheet, life insurers employ both structuring asset portfolios (on-balance-sheet hedging) and using interest rate derivatives (off-balance-sheet hedging). This paper attempts to uncover how the term structure factors and cross-sectional attributes of life insurers affect their hedging behaviors against interest rate risk, and the substitution of two hedging approaches. Analyzing the different incentives to employ the two approaches, it proposes that anticipating the rising (decline) of future interest rates life insurers tend to increase (reduce) the interest rate exposure in both assets and derivatives. Such hedging behavior is tested by finding the negative association between the term spread (proxying life insurers’ expectation of future treasury yields) and the dollar durations of bond portfolios and interest rate derivatives. The perfect substitution of one approach for the other in terms of hedging interest rate risk is supported by the negative correlation between gross risk exposure in assets including derivatives and the term spread.