Insurance Funds Investment Strategy and Risk Management Structure
Xiang Guo, Wen Wang
School of Insurance and Economics, University of International Business and Economics, Beijing, China
(gxinnofund@163.com, wangw6966@vip.sina.com)
Abstract - Three aspects — insurance companies'
own risk management capabilities, regulatory policy
and market constraints from the insured impacted the
use of funds in insurance companies. The three parts
interact, and ultimately determine the optimal
investment strategy. This paper takes insurance
companies, government regulation and market
discipline as research objects, to create a model which
contains elements of risk management. It also analyzes
the influence of risk management costs and the overall
level of risk management in insurance companies'
investment and information disclosure.
first part is a brief analysis of the existing problems in the
field. The second part introduces the literature on this
research. Third part is theoretical analysis in order to
discuss the internal logic based on risk management
perspective. The fourth section expanses theoretical
analysis, contributing to understand the information
transmission from the point of reserve extraction and
information disclosure. The last part is the conclusion of
the full paper.
Keywords - investment strategy; risk management
structure; liability reserve disclosure
Cramer (1930) conducted the first study of risk in
insurance investment noticing that insurance companies
need to focus on investment risk. Subsequently,
investment risk quantitative research on the insurance
company gradually started, and later formed random
distributions or complex process models describing the
probability of loss and loss function (Dickerson, 1961;
Joseph Neggars, 1964; Kahn, 1964). Most Scholars have
focused
their
attention
on
portfolio
theory
(Markowitz,1952) and finance theory (Sharpe, 1963;
Lintner, 1965; Mossin, 1966). From perspective of the
relationship between insurance companies' capital
structure and investment risk, Michaelsen and Goshay
(1976), Harrington and Nelson (1986) quantitative
analyzed the relevance between capital structure and
investment risk. When insurance companies invest the
greater proportion of debt funds, the investment risk
accordingly became smaller, so capital structure is an
important factor impact on investment risk.
Hoff Lander (1966), Kahane (1975) and Brigs EP
(1985) studied investment model on the assumption of the
insurers’ expected quadratic utility function. Frost (1983)
analyzed whether modern portfolio investment model was
feasible based on the insurance fund structure. Patterson
(1984) considered investment strategies in case of
guarantee payment. Moridaira (1992) added the portfolio
insurance to the CAPM model. Based on differences
between assets and liabilities income, Babble and Hogan
(1992) made models for shareholder and policyholders
value maximization. Leibowith, Kogelrnan and Bader
(1992) realized the maximize effect of capital gains,
which eventually determined the added value in asset
management process. In optimal portfolio of Markowitz
model, financial debt leverage has a greater impact on the
asset investors’ allocation. Empirical results confirmed
that shareholder decision will significantly affect financial
leverage, while surplus income method can internalize
this effect (Sharpe, Tint, 1992; Leibowith, Kogelman,
Bader,1994). How insurance companies choose to invest
I. INTRODUCTION
As Chinese insurance industry develops, issues on
insurance funds risk management have become research
hotspot in recent years. Risk management study on
insurance funds focuses on investment entities,
organizational structure, legal risk, early-warning systems
and protection mechanisms, etc. Analysis based on ERM
is a weak area. Even the practical risk management
analysis is concerned about areas such as the risk
management process and measures, no attention to the
company's overall risk management structure and external
regulation. Insurance regulation is an insurance
company's background environment, and regulatory
policies changes will have a direct impact on the
insurance company. As special financial institutions,
insurance institutions with a lower risk management level
have a motive for higher risk investment with less cost.
Due to the incomplete information and moral hazard,
regulatory agencies and the insured are difficult to draw
intuitive judgments for an insurance company’s' risk
management capability. So little it is known about the use
of insurance funds, lack of the overall control mechanism.
In the context of regulatory policy, we have adopted a
comprehensive analysis framework applying the
investment strategy based on the insurance company's risk
management structure variables. It combines the insured’s
expense requirements and market constraints of insurance
companies, hoping to build a theoretical model containing
the above three. The paper is structured as follows: the
____________________
Sponsored by Key Project of the Social Science Foundation (11AJY014),
Humanities and Social Sciences Planning Fund Supported by Chinese
Ministry of Education (10YJA790190), National "211" Key Disciplines
Project Construction in Phase III of UIBE (73000010).
II. LITERATURE
in the capital market to minimize the probability of
bankruptcy has become scholars’ study issue, such as the
Black-Scholes risk-based capital model, or Brown motion
with drift process (Browne, 1995).
Domestic investment in research unfolded as follows:
the insurance investment channels, investment regulations
(Li Xiaoming, 2000; Xiao Wen, Xie Wenwu, 2000). Lee
Lifei, Zhao Xuelei (2003) described risk process with
compound Poisson process, following Hipp Plum (2000).
Insurance company achieved optimal investment through
minimizing the probability of bankruptcy. Principal-agent
problem may exist in liabilities and earnings perspective.
Reasonable and effective risk investment model must be
constrained by risk and asset specificity (Qin Zhenqiu,
Zhou Chun, Yu Ziyou, Zhang Yadong, 2003).
As can be seen from the above literature review, the
domestic studies most unfolded in a practical point, lack
of theoretical research. Also these papers are only
extensions in empirical research methods, and less
concerned about risk management and disclosure in the
whole process. The impact of enterprise risk management
in control measures and information disclosure is not yet
clear, which becomes this papers’ research direction.
III. THEORETICAL ANALYSIS BASED ON THE
PERSPECTIVE OF INVESTMENT STRATEGY AND
RISK MANAGEMENT STRUCTURE
Risk management structure is a concept based on risk
management process costs and compensation incurred.
Different studies selected different indicators to measure
them. This paper divided it into two parts: the fixed cost
and variable cost. There exists the following condition:
less risk management costs may not stand for good risk
management conditions, so overall risk management level
variable is added for a specific risk management cost
structure. This risk management structure feasible set in
this paper contains three parts: the fixed cost, variable
cost and risk management level. Then the reserve is
introduced into the model as an agent variable for
insurance regulatory policy. For a certain insurance
reserve extraction ratio and optimal risk management
structure, how is the relation between investment strategy
and external regulatory?
A. Model Hypothesis
a) Insurance business is divided into three phases.
First they absorb the premium and to accrue liability
reserve. The second stage is to use insurance funds in
accordance with specific investment strategy. The third
stage is to make payments and to obtain the amount of
upfront investment income.
b) As reflected in this model, the insurance regulatory
bodies publish how the reserve is extracted. Insurance
companies determine their risk management structures.
Insurance companies have to pay the amount of
F payments in the end as external market constraint.
c) Each insurance company faces two types of
investment opportunities: risk-free investment and venture
investment. Risk-free investment opportunity exists with
profit I in the period end, while venture investment
includes speculative options. Due to the existence of nonsystematic risk, high-risk venture capital projects are also
possibly to obtain higher returns. Suppose the probability
of high returns is q with return H , the probability of low
returns is (1  q ) with return L , q ~ U (0,1) . Insurance
companies or asset management companies will examine
risk profiles of investment projects in detail, but
regulators and policyholders are difficult to obtain this
information. In the third stage, the final investment cash
flow value T depends on the insurance companies’
investment strategy in the former phase: if it invests riskfreely, then T  I ; otherwise T  H or T  L .
The elements set of risk management structure
include three factors: insurance companies’ fixed cost s ,
variable cost  and overall risk management level  .So
risk management structure is expressed as {s,  ,  } .
Because of small changes of fixed cost in risk
management, we do not include that value in the cash
flow, which means the numbers in the T  {H , I , L} have
subtracted s . In a given level of risk management,
insurance companies will choose investment strategy for
their own benefits, which are influenced by the risk
management structure variables  ,  and pay expenses F .
B. Optimal Investment Strategy
In connection with the model, we define the optimal
investment strategy of the insurance company. Under
conditions without considering the amount of expense, if
e
e
there exists q and 0  q  1 , insurance companies choose
e
venture investment when q  q .Otherwise they choose
e
risk-free investment when q  q . Then this strategy is
e
expressed as [q ] . Due to q ~ U (0,1) , insurance company’s
final cash flows probability distribution based on
e
investment strategy [q ] are calculated as follows:
1
e2
 2 (1  q )

p
qe
1
 (1  q e ) 2
2
T H
T I
T L
e
Expected value of cash flows under strategy [q ] is
expressed as E[q e ]
1
1
(1)
E[ q e ] 
(1  q e 2 ) H  q e I  (1  q e ) 2 L
2
2
As E[q e ] changes, the standard deviation  (qe ) is a
decreasing function. When q changes from 1 to 0,
 (qe ) increases from 0 to ( H  L )2 . First-order optimal
condition is qˆ  I  L
2
H L
ˆ] 
E[ q
1
1
ˆ 2 ) H  qI
ˆ  (1  q
ˆ)2 L
(1  q
2
2
(2)
(3)
When q e decreases gradually and  (qe ) increases
adversely, strategy moves towards risk-based investment.
E[q e ] first increases to maximum E[ qˆ ] , then gradually
reduced to H  L .
2
Formula (3) shows that only in strategy [ qˆ ] can
insurance companies achieve maximum return on
investment. Insurance companies should strive to
maintain the investment strategy [ qˆ ] in order to maximize
the expected cash flow and this investment strategy is
called optimal investment strategy.
C. Conclusions and Instructions Related to the Model
a) Risk management structure variables’ investment
(1   )   ( I  F )
qm 
(1
  )   ( H  F )
incentive function
(4)
In this conclusion, for a certain risk management
structure {s,  ,  } , this paper studies the impact of risk
management on investment options. Investment strategy
can be seen as the function qm ( ,  ) . We can see that
qm ( ,  )
is
an
increasing
function
of

from
qm ( ,  )
0

, which means the higher variable cost of
risk management, the more conservative investment
strategy insurance companies would take. We can also
find that qm ( ,  ) is a decreasing function of  from
qm ( ,  )
0

which means insurance companies incline
to take risker investments under higher level of risk
management. The significance of these findings is clear:
in a given  , the insurance company will gradually shift
to venture capital as  increases. In a given  , risk
management costs will be a financial burden on insurance
companies as  increases, and insurance companies will
choose
conservative
investment
strategy.


Therefore and have an opposite effect in investment
strategy choice.
For the expense F ( I  F  L) and risk management
structure {s,  ,  } the inference are as follows: (1)
When   0,   0 , risk management process has no
influence on insurance funds and insurance risk
management structure model degrades to the basic
model.(2)When I  F    0 ,   0 the risk
management level equals zero. That is to say, put into
much risk management resources but do not receive
corresponding effect. The strategy [qm ] equals [1] ,
insurance companies will take risk-free investment. (3)
  0,   0 is the optimal structure for companies. In this
circumstance, insurance companies can not only get the
benefits of risk management but also minimize the overall
cost. But the economic environment fluctuations actually
make it difficult to achieve this optimal state. The initial
cost in implementation of risk management will be larger
and decreases with in-depth risk management application
in all aspects of insurance sectors.
b) Risk management Structure and Reserve.
Insurance reserve  and claims paid F are interrelated.
If the reserves are independent of the insurance company's
risk management structure, insurance company will
choose risk management structure for their own
investment operations. But in fact, regulatory authorities
reserve policy needs to be more risk-prevention, so in this
paper we set the reserve accrual method related to
investment strategies. Given a payment level F ( F  H ) and
a risk management structure {s,  ,  } , a reasonable
reserves the extraction amount expresses as follows:


1
2

 m   qm ( F  I )  (1  qm ) 2 ( F  L) 

(5)
qm is determined by eq. (4) ，  m is determined by
F ,  ,  and income set {H , I , L} ,  as the scale factor.
Keep F and  constant, the insurance company managers
will seek to maximize their own interests. Equation (5)
reveals intrinsic relationship between reserves and the
above variables. The reserve reflected the investment
strategy and risk management structure which is the basis
for information disclosure. If reserves are formulated for
the optimal investment strategy, it can redress insurance
companies’ own strategy and risk management level:
if qm equals q̂ and companies don’t choose the appropriate
risk adjusted investment management structure for their
own business, the loss is T (qˆ )  T (qm ) .Given F ,Insurance
companies selected the corresponding risk management
structure for the investment, and also match the liability
reserves.
Risk Management Optimization. In eq.(5) under the
reserve extraction method established, insurance
companies will choose the risk management structure to
make the investment strategy q̂ . If the risk management
structure
variables
meet
the
following
ˆ
ˆ 
( F  L)
(1

ˆ )
condition
, risk management structure will
motivate
companies
to
choose
investment
q̂
strategies .The conclusion confirms that a risk-based
management structure will guide insurance managers
choose optimal investment strategy. Eq (6) represents the
risk management variables are not unique. And
d ˆ
F L

0
dˆ (1   )2
represents ̂ and ̂ have the same variation.
This is the same as the previous conclusion: When  is
big and  is small, qm  qˆ and more conservative
management is caused. When  is small and ̂ is large,
qm  qˆ
and the opposite effect promotes the insurance
fund managers to obtain better possible investment
strategies.
Analyze the above findings Together. From eq.(4), a
group of risk management structural parameters
q
determines a unique investment strategy m .Considering
the risk management structural parameters in
responsibility reserve equals to determining the specific
investment decisions. On this basis, the insurance
managers give priority to the optimal risk management
ˆ
structure {s,  , ˆ } with pre-determined commitment to
maximize the value of the investment. On the other hand,
from eq.(5), if the reserve extraction has nothing to do
ˆ ˆ
with the risk management structure {s,  ,  } ,
indicating qm is not fully internalized. Moreover it is clear
that risk management structure is determined by
company's maximize-value behavior choice. And even we
can predict the final investment strategy, risk-transfer
mechanism still exists, and q( F )  qˆ .
The role of risk management in insurance companies’
asset investment risk control has attracted a lot of scholars
to attention. Regulators could determine insurance
company's risk management structure with reserve
program. As conclusion above indicated, whether the
insurance company managers will choose an optimal risk
management structure depends on the specific programs
for the reserve. The theoretical model inherent structure
shows reserve fund withdrawal plan based on risk
management is the key to motivate managers to choose
the best insurance company's risk management structure,
while risk management structure will enable managers to
select an optimal investment strategy.
IV. INFORMATION DISCLOSURE AND RESERVE
THE EXTRACTION DESIGN IN INSURANCE
COMPANIES
Information and communication is an important
element
in
COSO-ERM
analysis
framework.
Traditionally, regulators and the stakeholders of insurance
company mainly access information through financial
statements. In the presence of financial fraud and number
whitewash conditions, it is difficult to obtain true risk
information. Even if the information is real stated, they
can only passive accept information, lack of means to
exert reasonable influence. The above analysis shows the
existence of a mechanism designed to encourage
insurance companies to select appropriate risk
management structure. This is the mechanism designed to
extract the reserve. Therefore, there is internal mechanism
for regulatory agencies to affect insurance sectors’ risk
management through design of regulatory measures. Of
course the mechanism is not only displayed as reserve
extraction in this paper. Far discussed in this section,
when risk management structure is incorporated into the
reserve extraction design, issues should be considered as
follows: after liability reserve has developed based on the
current situation, what would occur when the insurance
companies change their risk management structure? There
exist two different solutions: firstly, regulatory agencies
corresponding changes reserve extraction to adapt it. This
idea is actually unfeasible and the reason is that the risk
management level reduction may be a company’s single
act, but the extraction policy is the policy of the industry,
so adjust cost is large. Secondly, the final evaluation and
penalty methods can be used. With those who reduce risk
management level in each financial year, insurance
companies should be subject to additional regulatory
penalties. Regulators send control signals to the insurance
company by means of punishment.
The financial data of insurance funds do not directly
reflect their risk management, and risk management
related data refinement can be used as risk management
measure. Explore to establish the appropriate financial
and non-financial indicators effectively to represent the
insurance company's risk management capabilities.
Insurance companies can pre-select an optimal risk
management structure to show regulators and
policyholders their investment approach and the intent to
protect the interests of policyholders. Consider the
transparency of regulation in insurance companies. Owing
to the cost of information disclosure which is less than the
cost of regulatory supervision of both the insured and
regulation agency, public investment information
disclosure has a strong practical value.
In one sense, the responsibility reserve extraction is
equality to information disclosure. As long as the
insurance company's risk can be measured, information
disclosure will lead to more transparent investment
strategy. And that will encourage regulators to take more
effective control measures. High level of information
disclosure corresponds to a high level of supervision.
V. CONCLUSION
Combined with the insurance regulation, insurance
companies and market constraints in this paper, a
theoretical model is proposed for considering risk
management effect in insurance company investment. The
model results are discussed in the equilibrium when level
of risk and risk management can be measured. In reality,
due to the information collection and processing costs,
there is a big difficulty to measure accuracy of risk and
risk management level. Currently, papers widespread use
variance as an approximation of risk measure, and the
measures of risk management level can be considered by
using the possible loss ratio as an approximation (loss
amount prevented by risk management to the total loss
amount). However, these approximations still remain in
the initial stages of data use. How to effectively achieve
the quantification and measurement of these indicators is
the focus of follow-up study.
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