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Management & Regulation

Investing Insurance Funds

R. Vaidyanathan
< E X E C U T I V E S U M M A R Y >

nsurance companies are among the largest institutional investors in the world. Assets managed by insurance companies are estimated to account for over 40% of the world's top 100 asset managers. Insurance companies and private pension funds in the US constitute one of the largest institutional investor groups (fable 1). Nearly $300 billion was in the form of capital contributions by life insurers and pension plans.

IMPORTANCE OF INVESTMENT MANAGEMENT Investment operations are not to be considered as incidental but crucial to the business of insurance. Insurers are required to generate reserves for claims that might arise and over a period a large corpus of funds is built up. It is important that insurance companies invest these funds judiciously with the combined objectives of liquidity, maximisation of yield and safety. The returns on investments of life funds influence the premium rates and bonuses of life insurance business. It has to be ensured that the insurers must at all
The author is Professor of Finance, IIM Banga/ore.
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times maintain a prescribed minimum level of solvency as a protection to the policyholders legitimates interests. In this view of public interest, investment of insurance funds is regulated in some countries. Many countries do not have regulations to guide such investments, but they do have provisions setting out 'admissible' securities/assets for the purpose of determining solvency levels of insurance companies. It has been generally observed that underwriting spreads are minimal or negative in many cases. The financial performance of the General Insurance Company (GIC) and its subsidiaries (the monopoly in this field) is shown in Table 2. It indicate that the underwriting spreads are minimal and can be negative. Hence, the considerations of marketability and capital volatility will be important in the choice of assets in the context of net premiums being inadequate. Alberto Franceschett and Ronald P. O'Hanley points out that "From 1990 to 1994, US property and casualty investment income as a percentage of written net premiums was 19.1 percent, compared with an insurance underwriting result of -9.9 percent." They add that the "Leading performers in insurance investment management achieved considerably higher investment results than average players, with, for example, 1.3 percentage point higher returns in the US and
January 2001

Life Insurers, Commercial Banks, Mutual Funds, Pension Plans as Sources of Funds in the US Money

and Capital Markets ($ Billion)

Commercial Banks Mutual Funds Life Insurers Private Pension Plans
1987 128 55 95 36

1997 467 421 199 .86

and 1.4 in Germany. In the US, this translated into a 4 percentage point higher return on equity than the industry average". In addition, it is stated that "Some of the most notable losses in the industry have been related to investment: for instance, Equitable's real estate and GIC losses, Colonia's derivative losses, and First Executive's junk-bond losses. " Investment returns, particularly in emerging markets, are directly related to regulatory controls and management of investment. The aspects that impede an approach, which places primacy to investment in the insurance business, are: " Investment activities in the insurance industry have traditionally been viewed as ancillary or incidental to underwriting. In other words, it is argued that insurance is the 'business of generating liabilities that must be matched by investment in assets. Hence, much time and attention is spent by actuarial experts in forecasting pay out patterns and liabilities. Asset composition is arrived at after taking into account a safety factor for unexpected losses. Hence many Insurance Companies hold an asset mix that is highly, liquid and fixed income in nature, rather than an optimal portfolio mix for maximising benefits. Insurance companies take three types of risk namely underwriting risk (pricing); leverage risk (premium to surplus) and investment risk (choice of assets for invest

ment). In many insurance companies the underwriting unit managers are also held responsible for investment results. These managers may lack skills in investment management arid may go in for say more current yield rather than for optimal asset allocation decisions. The winners in the insurance industry are more identified in terms of superior marketing, better underwriting and top quality claim performance. In other words the success is measured more from the liability management coupled with average asset management rather than by the yardstick of successful investment practices. Considering these factors, it is required to closely look at the nature of investment management as well ~ the emerging trends in the new markets. FACTORS TO CONSIDER The pattern of investment for insurance companies and pension funds is primarily influenced by the nature of the liabilities- whether they are denominated in real or nominal terms. For example, the liabilities of a fairly young defined benefit pension plan is denominated in real terms which calls for a substantial investment in real assets such as equities and index linked gilts. It is also important to match assets and liabilities in terms of currency. The "typical" liability profile of insurance companies and pension funds is as follows. Life Insurance Companies: Generally, liabilities of life insurance companies are of longer term. The contractual liabilities (e.g. Liabilities under non-profit policies) are fixed and guaranteed. The noncontractual liabilities represent with profit policyholders' expectations regarding future bonuses. The expected future bonuses are akin to a real liability linked to inflation. Due to a continuous inflow of funds for a long period, liquidity is not an important factor for the fund. Many a times funds have large surplus assets. Incidence of income tax and capital gains tax applicable to life insurance companies is also an important factor influencing the asset allocation between fixed income and growth oriented investments.

GIC And Subsidiaries: Financial Performance (Rs crore) 94-95 95-96 96-97 97-98 98-99 -705 -646 -628 -384 -687 -14.45 -10.85 -9.33 -5.22 -8.17

Underwriting profit/losses ( ) % Net Premium

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January 2001

General Insurance Companies: Liabilities of general insurance companies are primarily of a shortterm nature. In general insurance business, most contracts are renewed each year, and claims are typically settled within a year or two from the date of incident. Since the contracts are subject to annual review, prospect of inflation substantially increasing the liabilities is fairly remote, and hence, funds need not be invested in assets of real nature. Liquidity (of investments) can be an over-riding consideration for general insurance companies with unfavourable underwriting experience. For instance the underwriting experience in the Indian context, as already indicated is provided in Table 2. Pension funds: In respect of defined benefit pension scheme, the liability structure will be primarily influenced by the age profile of the scheme membership. A final salary scheme with predominantly young members will have a large proportion o its f liabilities denominated in "real" terms: On the other hand a mature pension scheme dominated by pensioners will have a substantial proportion of its liabilities defined in "nominal" terms. The liability structure directly influences the asset allocation decision. A final salary scheme comprising mostly young members will have an investment portfolio tilted heavily in favour of equities. A very mature pension scheme will carry a near 100% fixed income oriented investment portfolio. The liability structure also indirectly influences the asset structure because it has a bearing on factors such as liquidity and marketability of investments. In the case of a defined contribution scheme, the liability of the scheme at any point is equal to the value of the investment portfolio of the scheme. Therefore it can be said that the liability structure does not impact the asset allocation decision. However, if the defined contribution scheme is based on a set of target pension benefits, the asset allocation decision will be guided by the nature of the target benefits expected from the scheme. A widely followed investment strategy in this context is the life style investment strategy. This strategy involves constructing and maintaining an investment portfolio heavily weighted in favour of equities up to, say, five years prior to the retirement age, and gradually shifting into fixed income securities closer to the retirement age. This strategy has been found to be quite effective in addressing risks such as inflation risk and capital risk faced by the members of a defined contribution scheme.

INVESTMENT REGULATION AND MANAGEMENT Hence, the regulation of investment of insurance companies need to focus on: Solvency requirements Asset valuation regulation Minimum percentage of the fund to be invested in certain asset categories Restriction on the maximum amount of investment in certain classes of assets Restriction on the percentage of funds that can be invested in any one company/industry Treating some assets as inadmissible for valuation purposes Compulsory coverage of technical commitments by assets specified by the regulatory authority is a feature in many developing countries. The regulator seeks to maintain the solvency of the concern and also ensure that the technical reserves, which are considered as part of the national savings, are invested in socially relevant or priority sectors of the economy.

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THE REGULATORY FRAMEWORK Broadly there are two regulatory models governing investment policies of insurance companies and pension funds-the Prescriptive Model and the PrudentMan Model. The Prescriptive Model is one where the asset allocation decisions of these institutional investors are dictated by a mandated investment pattern. This is followed in countries like India, Canada, Italy, Japan and South Korea. On the other hand, the Prudent-Man Model is one where there is no mandated investment pattern, but "eligible assets" and "admissibility limits" must back the prescribed minimum solvency related to eligible assets. This model indirectly influences the asset allocation decisions of the insurance companies and pension funds. This model is adopted in countries such as the US, UK, France and Spain.


Most foreign countries have regulations that cover the assets of the insurer. But the extent to which these regulations seek to control the assets of the insurance company, differ from country to country. Regulations are set on the basis of the economic environment prevailing in the country. These regulations could involve restrictions being placed on the maximum or minimum to be invested in any particular asset, restrictions on the

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January 2001

Growth in General Account, Separate account and the total assets of the US Life Insurance Companies ($ millions) 1986 109 829 1997 736 1843

Separate Account General Account

percentage that can be invested in any particular industry and localisation of investments to name a few.

The investment activities of the insurance companies in the US are governed by the State Insurance Law and Regulations. Though these laws are state specific there are commonalties because of the generic nature of the problems and the role of the National Association of Insurance Commissioners (NAIC) and the requirement that a foreign insurer licensed to do business in the state, must comply with the state law. Investment regulations specify the following: ?? The types of investments that are eligible (bonds, preferred mortgages and common stocks etc') ?? The minimum quality criteria for individual "investments within the eligible categories. ?? Commercial mortgages are subject to 75% loan-tovalue limit. ?? Common stock up to a limit of 1 0% and real estate up to 20%. ?? The state law also specifies asset valuation. The state law also mentions the method of valuation i.e., bonds are valued on an amortised basis, and, the stocks are valued at cost or market; price, whichever is lower. ?? Certain types of assets are not admitted for the purpose of state regulation. These typically include office furniture, overdue balances from agents' etc. ?? All classes of assets including real estate are exposed to reserving rules. ?? For the purpose of investment regulation, a company's capitalisation is measured by either networth to total assets or ratio of capital to risk weighted assets. ?? As regards the life insurers, they invest in the debt and equity issues of types of companies and they also make direct investment in mortgage loans for real estate like office buildings, apartment buildings, and shopping arcades. Besides, they are also major buyers of Government. Securities. The total investment portfolio of a life insurance

company can be separated into two categories. T he accounts are classified primarily according to the nature of the liabilities for which the assets are being invested. These two categories are: ?? Assets supporting the insurer's General Account ?? Assets supporting Separate Accounts Assets that are used to support contractual obligations providing for guaranteed, fixed benefit payments are normally held in the company's General Account. Other invested assets, used to support the liabilities associated with investment risk pass-through products or lines of business (e.g., variable annuities, variable life insurance and pension products) are held in special accounts named Separate Account. A Separate Account is held separately from all other assets. These accounts were first used by US life insurance companies in connection with their pension business in the early 1960s. State laws provide that assets in appropriate Separate Accounts may be invested without regard to the restrictions, which are placed on the General Account investments. Hence a separate account portfolio may comprise of only common stocks, only bonds, only mortgages or any combination of these and other investments. Nearly 25% of all assets of US life insurers are held in Separate Accounts, (see table 3). Table 3 provides the growth in General Account, Separate Accounts and Total Assets of US life insurers. The greater growth seen in Separate compared to General Accounts is due to the higher demand for variable products. Mix Of Assets And Asset Classes US life insurance companies hold and manage assets of more than $ 2.6 trillion. The largest investment category consists of corporate bonds (more than 40%) followed by equity holdings (23%). Real estate mortgage loans account for 8% and treasury and federal securities account for another 15%. Investment in securities of

TABLE-4 Distribution of assets of US Life Insurers ( 1997 )

Corporate Bonds Stocks Miscellaneous Policy Loans Government Bonds Real Estate Mortgages' 41.1 0% 23.20% 6.50% 4.10% 15.20% 1.80% 8.10%

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January 2001

US Life Insurers' General Account Assets Mix 1986 and 1997 1986 Bonds 50 Stocks 10 Mortgages and Real Estate 25 Policy Loans 5 Miscellaneous Assets 10 1997 70 5 15 5 5

other countries' governments and international agencies, have always been small (1.5% of total assets). Investments in both long and short-term non-US corporate debt obligation represent less than 5% and it is mostly Canadian securities. Policy loans, which are taken at the option of the policy owner, constitute 4%. Although these are considered invested assets, they are not the responsibility of the investment department. Table 4 provides the distribution of the assets of US life insurers at the end of 1997. We have provided in Table 5 the distribution of the US life industry General Account assets , which shows that bonds constitute the largest chunk. It is also to be noted that 94% of General Account bonds were investment grade, at the end of year1997.

Mix Of Separate Account Assets

As indicated earlier, separate accounts are used to support liabilities associated with investment risk passthrough products or lines of businesses such as variable annuities, variable life insurance and pension products. In these products, the investment risk has been transferred to the customers. They may be invested without regard to state laws, regulating the investment of General Account assets. Investment managers are free to allocate assets among any investments available in the market. Pension customers may and frequently do participate in the allocation decisions. Table 6 shows the distribution of separate account assets of US life insurers during 1997. We find that the corporate stocks constitute more than 70% of the assets. Separate account assets have also grown from 13% to almost 30% of total assets. In 1996, the NAIC adopted a new version of its 1992 model investment law titled "Investments of Insurers Model Act (defined limits version)", similar in structure to the current regulatory scheme.

It includes refinements intended to address the asset quality concerns that have developed in the industry. The most significant new provision permits the subjective determination by a commissioner that specific investment activities endangers an insurer's solvency and provides authorisation to limit or prescribe those activities. Such a provision considerably expanded regulatory powers over investment activities. In 1998, the NAIC adopted the "Investments of Insurer's Model Act (defined standards version)". This model investment law (called the "prudent person model'') is intended to serve as an alternative to the "Investments of Insurer's Model Act (defined limits version)". This act is structurally designed so that the insurer is subject to the following type of investment regulation. . An insurer is obligated to fulfil the minimum asset requirement as that term is defined under the act. The minimum asset requirement is made up of an insurer's liabilities and what is called the "minimum financial security benchmark". This benchmark equals either the company's minimum capital as required by the statute or the authorised controlled level risk based capital, which applies to the insurer as set forth in the risk based capital law of the state, whichever is greater An insurer is obligated to invest its assets after fulfiling the minimum asset requirement in accordance with a prudent standard. In this respect the act sets forth factors that must be evaluated by the insurer in determining whether its investment portfolio or policy is prudent.

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UK has probably the most liberal regimes. No specific rules indicating the assets in which investments can be made. Regulations lay down rules regarding Type of assets: TABLE - 6 Distribution of US Life Insurers' Separate Account Assets (1997) Corporate Stocks Mortgage Loans and Real Estate Policy Loans Miscellaneous Assets Bonds 70.60% 2.50% 0.30% 9.20% 17.40%

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January 2001

Clear terms of reference should be produced for the investment managers even where these Asset Allocation of UK Long Term Insurance are in-house. These will probably include specific category limits, legislative constraints, Companies* desired risk/reward balance, composition of liabilities and policyholder's reasonable UK equities 39% expectations UK fixed interest securities 23% Special attention must be paid to derivatives Index Linked Gilts 2% Appropriate resources must be allocated to Overseas Equities 11 % these tasks Overseas fixed interest securities 3% The Board must discuss all these matters reguProperty 9% larly so as to be satisfied of compliance Cash 3% Appointed actuaries have an important role to Units of Unit Trusts 7% play in terms of Others 3% Set up specific reserves for possible future * Figures based on Financial Statistics 1995; changes in the value of the assets HMSO Ensure that the investment policy followed by directors is in consonance with the nature and the term Extent to which they can be invested in. of the company liability. Basis of valuation Advice about the constraints on the investment The investment policy and valuation of the assets are policy needed to protect the interest of the responsibilities of the directors. policyholders. Prudential Guidance Note issued by DTI (which was Table -7 presents the average asset allocation responsible for administering the Insurance Act prior to pattern for the life insurance industry in the UK While the setting up of the FSA in 1998) in 1994 needs to be interpreting Table -7, it needs to be noted that different followed by the directors. life offices can have investment distributions which The board of the company should determine, vary significantly from the pattern presented in the implement and monitor an investment strategy Table, as a result of having different liability profiles, reflecting, different solvency margins, etc. Table -8 presents the The requirements of appropriate safety yield and mar- average asset allocation pattern of general insurance ketability. companies in UK. Appropriately diversified and adequately spread assets. TABLE- 8 Matching and localisation requirements Avoidance of speculative trading in financial Asset Allocation Pattern of UK general instruments Insurance Companies (excluding long term Application of assets for long term business and business)* The observance of prudential guidance notes Type of Investment (%) The board should also be aware of the responsibility UK Equities 16 of the appointed actuary, in particular the duty to advise UK Fixed Interest Securities 28 about an appropriate investment policy for a long term Index Linked Gilts 1 fund and should ensure that the actuary is in a position Overseas Equities 4 to discharge those responsibilities. Overseas Fixed Interest Management control and information systems should Securities 11 be established to carry out the strategy to enable the Property 3 board to monitor its progress Cash & Short Term Assets 10 The board of directors should receive reports at an Others** 27 appropriate frequency with appropriate details as to *Compiled from Financial Statistics, 1995, investment activities and controls . HMSO The credit worthiness of counterparts (including rein**This category includes overseas loans and surers) should be regularly verified and systems must be mortgages, British Government Foreign Currency established to monitor aggregate exposure and to set Securities and direct investment. lower limits if appropriate


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January 2001

TABLE-9 Asset Allocation Pattern for UK Pension Fund Type of Investment % UK Equities 51 UK Fixed Interest Securities 7 Overseas Equities 22 Overseas Fixed Interest Securities 3 UK property 5 Index Linked Gilts 5 Cash & Deposits 5 Others 2 Source: Pension Funds and their Advisers, 1998 Table -9 presents an average asset allocation pattern for UK Pension Funds. We note that substantial allocation has been done for equities in the case of the pension funds and these funds play an important role in the capital market. Given the nature of asset liability structure it is natural that larger focus is on equity investment by the pension funds. Japan The modus operandi of investment is clearly expressed in the "Statement Showing the Methods of Utilising Assets" which is subject to the approval of Ministry of Finance. This document sets forth the kinds of investible assets and their scope for investments. The Enforcement Regulations provide that an Insurance Company must invest in the following manner: Japanese Government. Bonds, Local Government. Bonds, Debentures or Stocks. . Government. Bonds, Debentures or Stocks of foreign countries. Secured Loan. Real Estate. Loans according to policy conditions. Postal Savings or Bank Deposits. Money Trust or Security Trust in Companies. Any other manner approved by the Ministry of Finance.

covers are required. Foreign investment is permitted up to the amount of commitments' contracted in foreign currencies, if any. . Middle East Countries In the Middle-East countries, the regulations of insurance investments vary. In some of these countries, the respective supervisory authority is empowered to issue rules concerning the valuation of funds allocated to cover mathematical reserves. In others, the systems in force are not confined to insurance concerns - they are subject to the general laws laid down for all investments, and require the valuation of assets to be supervised by the auditors. France The assets have to back the technical and mathematical reserves. The assets in the same currency upto 80% should back liabilities in one currency. . The allocation of regulated assets will have the following cap condition: 65% for Stocks; 40% for Real Estate; 10% for Loans.

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Germany Assets backing reserves for policyholder liabilities may be invested in Mortgages; Government. issued or equivalent Bonds; Certain Industrial Debentures; Loans including Policy Loans; Bank Deposits. Investments may also be made in Equities Investment Trusts Property Property Investment Trusts Foreign Bonds and Shares.

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Currently, insurance companies and approved pension funds in India are subject to the prescriptive model. The mandated investment patterns applicable to these institutional investors are presented in Appendix l. We find that the prescriptive model is used wherein substantial amount of funds are identified with government related investments. This give rise to the interesting issue of the ability of the funds to earn adequate return on their investments given the low yields from the government securities. Perhaps the time has come for the regulator to
January 2001.

Latin American Countries Among some of the Latin American countries, the supervisory authority takes note of the fact that owing to the nature of the respective commitments in Life Insurance and Non-Life Insurance, different types of
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closely look at the prescriptive model and the prescriptions and see whether a larger elbow room can be created for the new and existing insurers to look at opportunities which are available from corporate securities both debt and equity. This is all the more important since insurance and pension funds are looked upon as an important source of funding of large scale infrastructure projects and many of these projects are encouraged to be done by private sector due to the reform process. Already, we find that the guidelines for linked and non-linked pension funds are providing larger scope for investing in market securities. In the context of companies honing their skills in portfolio management, stock selection techniques and net based decision making, it is needed for providing more opportunities for them to participate in corporate debt and equity paper. Since the credit rating companies are in place, it would be easier for insurance funds to evaluate the corporate papers in a rigorous fashion and utilise at least their early money portion to these issues so that attractive returns are earned commensurate with the risk. A combination of prescriptive and prudential model may be more useful in a developing country like India, which needs large institutional funds for its developmental activities.

Appendix 1 Mandated Investment Patterns for Insurance Funds: Indian Context The existing pattern relating to investment of life funds is as under: Type o f Investments Percentage of controlled funds (i) Government Securities 25% (ii) Government Securities or other approved securities (including (i) above) Not Less 50% (iii) approved investments as specified in Schedule I (a) Infrastructure and social sector Not Less Than 15% (b) Others to be governed by Exposure/prudential norms (specified in Regulation 5) Not exceeding 20 % (iv)Other than in Approved Investments to be governed by Exposure/Prudential norms Not exceeding 15 % specified in Regulation 5 Note: No unapproved investments be made and investments made in graded securities with very strong rating by a reputed agency (AA of S&P)

The existing pattern relating to investment of General Insurance funds is as under: Type of Investments Percentage of Total assets i) Central Government Securities, being not less than 20% ii) State Government Securities and other guaranteed securities 30% including (i) above, being not less than iii) Housing and loans to State Government for housing and fire 5% fighting equipment, being not less than iv) Investments in approved investments as specified in Schedule II Not Less Than 10% a) Infrastructure and social sector b) Others to be governed by Exposure/Prudential Norms specified in Not exceeding 30 % Regulation 5 c) Other than in Approved Investments to be governed by Exposure/ Not Exceeding 25 % Prudential Norms specified in Regulation 5.
Note: All investments in graded securities as in the "Life" case

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January 2001