• Mohamed El-Dishish

Chief Executive at insurance institute of Egypt

CPA from American Institute of Certified Public Accountants
Cairo - EGYPT

1
 Insurance Companies Investments
Chapter One
External Factors affecting investment decisions

Dr. Mohamed Eldishish

2
 Definition of External Factors:
• External factors are important when making investment decisions and
can have as much, if not more, influence on the decisions being made
than any individual characteristics or constraints.

3
 Categories of External Factors:
• The main categories of external factors are, all of which will be discussed, include:
❑ Cultural/social values.
❑ Demographics.
❑ Governmental influences.
❑ Economic and business environment.
• Many external factors could fit into more than one category. For example, financial
accounting rules could be considered either a governmental factor or a business factor.
• External factors can be interconnected or interdependent. For example, inflation (an
economic force) can be affected by the actions of the central bank, weather, business
competition, etc.

4
 Categories of External Factors:
• In developing an investment strategy, each individual or company
considers its risk tolerance, market outlook, and the effects on its
liabilities. For example, risk tolerance affects the work of decision
marker in all practices area, especially as it pertains to the company.
• Different companies have different risk tolerances, depending on factors
such as the company’s surplus position, the emphasis placed on earnings
stability, the main time horizon of the associated investment strategy, the
economic outlook, and the ability of the organization to manage risk.

5
 ❑ Cultural/Social Values:
• Each society is made up of people with similar sets of values and norms.
This combination of patterns and norms serves to regulate the society’s
behaviour. Any large society, such as a country, is comprised of many
smaller societies.
• Investment decisions are influenced jointly by social trends, cultural
beliefs, and economic trends.
• Social trends include the ever-expanding array of investment choices,
the increasing use of the internet for investing, day trading, investor
confidence (or overconfidence), and socially responsible investing
(SRI).
6
 ❑ Cultural/Social Values:
• SRI refers to an investment strategy that simultaneously attempts to maximize financial
return and satisfy both social and environmental aims through three sub-categories:
➢ Screening: where social and/or environmental criteria are used to decide whether or
not an investment should be undertaken.
➢ Shareholder advocacy: involves efforts taken to continually improve corporate
practices from an ownership perspectives
➢ Community investing: funds are allocated towards community projects or
organizations that are not as favored by traditional financing activities. Financial
service organizations are increasingly creating investment products and funds with
social and environmental aspects to which investors can direct their premiums.

7
 ❑ Cultural/Social Values:
• Changing cultural beliefs with regard to family versus individual
responsibility can also affect the design of government programs
such as social security.
• If a society has stronger dependence on family units, it will
depend less on government to fill any gaps in retirement funding.
8
 ❑ Cultural/Social Values Example: Healthcare
• Health care can illustrate the significant effect that differing social values have on the design of a
solution. All countries recognize the importance of health care, but various countries have
developed significantly different solutions to the problem of how to pay for it. An important factor
in determining the solution adopted by a country is whether the society relies more on
government or private institutions to address social issues. Two countries that illustrate this
difference are Canada and the United States.(Not Really )
• Canada relies heavily on the government to pay for and provide health care for everyone who
lives in Canada. However, the system does not include prescription drug benefits for people under
65. Hospitals are generally government owned. Supplemental private insurance is available.
• The United States, in contrast, uses a solution that relies heavily on employers and individuals to
purchase health insurance from private companies. The governmental role is focused primarily on
providing health care benefits for retirees over age 65 and for the poor through the public
programs.
9
 ❑ Demographics:
• Demographics are current population characteristics and trends over time. Since most actuarial
problems and solutions involve people, demographic forces have a significant effect on actuarial
work. Some population characteristics or trends that are often significant to actuaries are:
▪ Changing age distribution of the population.
▪ Fertility rates.
▪ Mortality rates.
▪ Changes in life expectancy.
▪ Distribution by gender.
▪ Morbidity (illness) patterns.
▪ Employment patterns, including workforce mobility and retirement rates by age.
▪ Geographic distribution.

10
 ❑ Demographics:
• Companies need to provide products that match the investment needs of their
customers, and these needs change over time and with age. Actuaries use
demographic information, recent experience, and projections of current trends to
arrive at the assumptions needed to develop investment policies.
• An individual’s age is perhaps the most essential demographic variable that
affects investment projections. Individuals in their early working years (25-44)
tend to invest more aggressively than those closer to retirement because they
have more time to make up for any short-term investment losses. However, as
workers approach retirement age, their investment objectives will shift from
growth (capital appreciation) to income (capital preservation) considerations.

11
 ❑ Demographics: Example
• You are an investment advisor with two clients. Client A is
age 30, married with two young children, and has given you
50,000 to invest. Client B is age 60, married with two grown
children, and has given you 500,000 to invest.
What are some differences in the investment strategies you
would recommend to these two clients?
12
 Demographics: Solution
Client A
• The strategy for client A should be
more aggressive, with emphasis on
capital appreciation, especially since
client A will need to accumulate funds
for upcoming large expenditures such
as buying a house or funding the
children’s college education
13
Client B
• The strategy for client B should be
more conservative (i.e., lower risk
tolerance relative to client A), with
emphasis on preserving the
majority of the 500,000 of capital
that has been accumulated to date.
• Client B will be reaching retirement
age soon and being able to provide
a retirement income so that client B
can maintain a standard of living
should be a essential concern.
 ❑ Governmental Influences:
• The government influences finance and investment decisions through regulatory,
fiscal, and monetary policies.
• We will discuss such influences from the perspective of corporate investors who
have a fiduciary responsibility to their shareholders. Likewise, institutional
investors such as insurance companies must make investment decisions that are
aligned with the well-being of their policyholders.
• Regulations are imposed so that institutional investors will have safety of
principal, stability of value, sufficient liquidity, appropriate diversification, and a
reasonable relationship between assets and liabilities. The extent of regulation
will differ substantially by industry, country, and region.

14
 ❑ Economic/Business Environment:
• Investment behavior is also related to the prevailing conditions in the economic
and business environment.
• An unfavorable economic climate may induce some investors to abandon certain
sectors, asset types, or individual securities.
• For example, in times of trouble, investors may reallocate funds to treasuries or
gold or simply keep significant amounts of money outside the market altogether.
Also, with all the occurrences of accounting fraud over the last 10-15 years,
investor trust and confidence may have significantly eroded.

15
 ❑ Economic/Business Environment:
• The economic environment encompasses factors such as productivity, income,
wealth, inflation, balance of payments, pricing, poverty, interest rates, credit,
transportation and employment. It is the totality of the economic surroundings
that affect a company’s markets and its opportunities.
• The business environment encompasses the way in which business is conducted
in the society, including the basic business economic model followed (such as
capitalist or socialist) and the regulatory/legal constraints.

16
 ❑ Economic/Business Environment:
• When actuaries develop solutions within economic and business contexts, they
must consider issues relating to portfolio management, asset allocation, fixed-
income securities, and globalization.
• For both retirement funds and insurance products, there is often a long time
horizon between when fund/premiums are collected from individuals and when
benefits/claims are paid out. The investment actuary is charged with managing
asset portfolios so that payments can be made when due, both on a short-and
lone-term basis.

17
 ❑ Economic/Business Environment:
• Effective portfolio management requires knowledge about the various capital
markets and an understanding of an investor’s objectives and constraints, so that
the optimal combination of assets can be formed.
• Asset allocation concerns the asset classes that will be utilized and the proportion
of total assets allocated to each class.
• Asset allocations have greater effects on determining overall return than
individual security selection.

18
 ❑ Economic/Business Environment:
• There are three steps to a typical asset allocation process:
1) The portfolio manager should identify the fund’s objective, for both insurance
companies and pension fund, this is often the maximization of surplus (i.e. the
excess of assets over liabilities).
2) The efficient frontier should be formed, where by either expected surplus is
maximized for a given level of risk ( as measured by standard deviation) or risk
is minimized for a given level of surplus.
3) The ultimate mix must be tailored to the individual investor and examined to see
if any regulatory constraints have been violated.

19
 ❑ Economic/Business Environment:
• Business cycle: when choosing between several alternatives, it is imperative that
each alternative be compared over the same time period. If the alternatives are of
the same length, but are compared over different time periods, then it is likely
that business cycles will affect the comparison.
• For example: If two alternatives are of different length, where the length of the
longer alternative is a multiple of that of the shorter alternative, and the shorter
alternative’s period coincides with a typical business cycle, a valid comparison
can still be made. The necessary adjustment is to repeat the shorter alternative
until its time period matches that of the longer alternative.

20
 ❑ Economic/Business Environment:
• Inflation: cash flows can be described using wither actual values or using values
that reflect purchasing power relative to a previous time point
• For Example: If 2005 is the reference year, and we are looking at real prices five
years ahead (in 2010), those prices would be relative to what actual prices were in
2005 rather than what actual or “nominal: prices are in 2010. regardless of
whether real cash flows or nominal cash flows are used.

21
 ❑ Economic/Business Environment:
• Inflation:
Fisher hypothesis for calculating nominal interest rate:
1) Exact nominal interest rate:
𝑟 = 1 + 𝑟0 1 + 𝑓 − 1
2) Approximate nominal interest rate:
𝑟 = 𝑟0 + 𝑓
𝒓 → the nominal interest rate.
𝑟0 → the real interest rate.
𝑓 → the expected inflation rate.

22
❑ Economic/Business Environment Example: Inflation and
Retirement Income
• While inflation’s effect on workers can be offset by pay increases, the same is not always true for
retirees. Retirees rely on pension income and investments. Price increases can reduce their
purchasing power and their standards of living. This problem may be addressed in various ways:
1) Providing monthly benefits that increase with price increases, such as U.S. Social Security
benefits. This may result in lower initial benefits, but a level standard of living.
2) Providing variable annuities that increase or decrease based on underlying investment
performance. This moves both the opportunity for superior performance and the risk of poor
performance to the retiree.
3) Investing personal assets in higher yielding investments, such as stocks. Higher investment
yields allow for larger withdrawals without reducing the principal, but generally increase the risk
of negative returns.
4) Increasing savings prior to retirement without increased withdrawals in the early retirement
23 years.