34 Journal of Insurance Issues, 2011, 34 (1): 34–67. Copyright © 2011 by the Western Risk and Insurance Association. All rights reserved. How Does the Liability Structure Affect Incentives to Invest in Hedge Funds? The Case of With-Profit Life Insurance 1 Thomas R. Berry-Stölzle 2 , Hendrik Kläver 3 , and Shen Qiu 4 Abstract: This paper investigates the impact of a life insurer’s liability structure on its incentives to invest in hedge funds. The analysis is based on a simulation model of a life insurance company selling with-profit life insurance policies with cliquet-style interest rate guarantees. The insurer has three investment alternatives: stocks, bonds, and a hedge fund. We maximize the insurer’s investment portfolio returns for given levels of insolvency risk measured by the insurer’s shortfall probability. A profit- maximizing insurer has incentives to invest in hedge funds if such investments increase the portfolio return for a given shortfall probability. The focus of our analysis is on incentive differences for different liability parameterizations. Our analysis reveals, first, that insurers with high interest rate guarantees, and financially weak insurers, have a higher incentive to invest in hedge funds, and, second, the optimal hedge fund holding of these insurers is very sensitive to expectations about future hedge fund returns. This interdependence is of importance to insurance companies, stakeholders, and especially regulators, since the strong incentives for financially weak insurers might create a moral hazard to overinvest. [Key words: Life insurance, hedge funds, over-investment.] 1 The authors thank James I. Hilliard, Robert E. Hoyt, Monica Marin, Heinrich R. Schradin, and the Editors and anonymous reviewers of this Journal for helpful comments and sugges- tions on this paper. Thomas R. Berry-Stölzle gratefully acknowledges financial support from the AXA Colonia-Studienstiftung im Stifterverband für die Deutsche Wissenschaft. 2 Terry College of Business, University of Georgia, trbs@terry.uga.edu 3 Institute for Insurance Science, University of Cologne 4 Institute for Insurance Science, University of Cologne