Capital Markets: Insurance and Contractual Savings

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Insurance and Contractual Savings
Overview:
There has been little explicit work done in the World Bank on the roles of the
institutional investors (on both asset and liability sides of their balance sheets) in capital
market and real sector development. A number of econometric studies have been carried
out but these have not been translated into policy statements. Operational involvement
has been ad hoc and largely through TA rather than lending activities (e.g. the funds
management advice being provided to India as part of the introduction of the new Civil
Service DC arrangements). An indirect attack on the issue has been made through a
number of FSAP assessments as the Insurance Methodology includes an ‘Assets’ Core
Principle. However these assessments have had a prudential/ market conduct rather than
a broad developmental bias. Finally, there is an onging dialogue within the Financial
Sector anchor about integrating the work of the Contractual Savings and Insurance (CSI)
and Capital Markets (CM) teams, with the annuities markets work being the most
tangible example to date.
Sectorial Issues:
There appears to be a typical power curve linkage between stage of economic growth and
development of institutional investors, with an exponent of around 1.4 (Chart 1).
Chart 1: Institutional Investor Growth - OECD
Ln Institutional Investment as % GDP
6
5
Korea
4
Norway
3
2
1
0
0
0.5
1
1.5
2
2.5
3
Ln GDP/ Capita
Source: Source: OECD Institutional Investor’s Statistical Yearbook 2003
In most countries institutional investors comprise the second largest set of financial
intermediaries after the deposit takers, although in developing markets they have
3.5
4
typically been much smaller, and largely reflect non life insurer’s assets. In some
advanced industrial markets institutional investors are the largest financial sector
component (particularly when measured in terms of domestic liabilities).
The two elements of the insurance sector are non life and life. They are in fact so
different that they might be seen as different sectors1. As a key real sector risk
management instrument non life insurance is an intrinsic part of any economy and there
is a very clear power curve relationship between economic growth and non life density2.
The non life sector is typically the 4th or 5th largest holder of financial assets, but risk
management considerations mandate relatively high liquidity and should (but does not
always in practice) limit the scope for riskier investment allocations 3.
The asset intensive mainstream life insurance sector has a more complex relationship
with the local environment (Chart 2).
Chart 2: Life Insurance Growth Determinants
Outliers
Life Prem./ Capita
3,500
United Kingdom
3,000
2,500
2,000
Denmark
1,500
1,000
Austria
S. Korea
500
HK
Iceland
0
0
10,000
20,000
Norway
30,000
40,000
50,000
GDP/ Capita
Source: Swiss Re. 2001 cross country data
The major drivers of life sector growth are development of a middle class, the tax regime
and the role and management of funded pensions. All the countries in the lower right
hand quadrant of Chart 2 have generous retirement arrangements and these are either
unfunded, or handled largely through intermediaries other than insurers (although, as in
Austria, they are often de facto insurers). South Korea’s life insurance industry has the
characteristics of a secondary banking sector, while the United Kingdom life insurance
1
There are some arguments for seeing non life insurance as a form of commerce and life insurance as a
close cousin to banking, especially as convergence becomes more universal.
2
For every 1% increase in GDP/ capita non life premiums per capita grow by around 1.3%. Non life assets
approximate non life annual premiums in most markets.
3
Non life insurers, and the monolines in particular, have a growing indirect role on the liability side as
credit enhancers for structured instruments and as direct credit risk insurers.
sector retains strong roles in both retirement savings and mortgage funding and in the
past enjoyed considerable tax advantages. If these path dependent outliers are removed it
is seen that the life insurance sector has typically grown considerably faster than other
institutional investors once a minimum wealth threshhold has been attained.
In some developing countries intermediate entities have sprung up which purport to
provide life insurance like benefits (e.g. Pre Need companies in the Philippines and
funeral societies in Africa). These are often sold to the poorer, less educated sections of
the community and are less vigorously regulated than life insurers. The funds
accumulated under these schemes sometimes support the business activities of companies
associated with their management vehicles, and usually do not add significantly to
economic development.
The introduction of supplementary pension systems in many developing and emerging
markets is likely to change historic patters, with a more rapid early build up of
institutional investment funds. The impact of pensions policy in industrial markets is less
clear. In Australia where life insurance and private funded pensions have equated to
approximately 45% of household financial assets for a decade, they went from parity in
1993 to private pensions entities5 being a significantly larger component by 2001.
Regardless of institutional form there will be an enormous build up of funds in industrial
countries and these will be seeking international investment opportunities (Chart 3).
Chart 3 – Global build up of pension and insurance funds 2002 to 2015
Funds Growth Sources
70
60
50
40
funding Increments
$Trillion
Retirees
30
New Members
20
Regular Growth
2002
10
0
-10
1
2
3
4
5
6
Category Build Up
Source: ING
5
Which benefit from reduced income tax on contributions and a mandated minimum employer contribution
level.
The tax aspect to some extent also accounts for the fact that in the OECD countries
investment companies (including mutual funds) now rival life insurers in terms of assets
under management (each controls 32% of all institutional assets). The proceeds of a life
insurance policy are typically tax free in the hands of the policyholder, who effectively
recieves the insurance company’s tax rate. Investment companies pass tax through at the
investors own marginal tax rate, although they have some influence over when the tax
liability is realized. Thus high income earners should have a preference for life products
if the pure insurance aspect is discounted. In practice life insurers usually have higher
expense rates, largely reflecting the use of inefficient agency systems, and this can vitiate
any tax arbitrage.
The overall trend is likely to see disintermediation continuing in most countries, although
the rate and pattern will vary according to development stage and prior path (Table 1):
Table 1: Institutional investment as a % of household financial assets:
Country Institution
1995
2001
3.9
4.6
Hungary Life
Investment Co.
0.7
5.3
Private pension
0.0
5.4
2.7
7.7
Portugal Life
Pension Funds
4.5
6.2
Life
14.5
23.1
Sweden
Investment Co.
6.7
10.6
Life
6.6
7.1
USA
Investment Co. (open)
5.8
9.0
Pension
19.7
20.0
Source: OECD Institutional Investor’s Statistical Yearbook 2003
Asset Allocation Implications
The choice of long term savings institutions will not in the future be neutral in terms of
subsequent asset allocation. A life insurer’s main competitive advantage is that it can
offer embedded options in its products. The most common is a modest guaranteed
minimum return at the end of the policy period, a relatively benign option. The existence
of embedded options which can be triggered before a policy’s maturity date
(increasingly popular in developing markets) can create dynamic liability durations which
are difficult to hedge in even the most developed capital markets6. Despite this there has
been little relationship between capital requirements and the level of mismatching
between assets and liabilities, at least outside the English speaking world, Northern
Europe and the more advanced S.E. Asian countries (Table 2). The gradual introduction
of risk based capital to other jurisdictions will undoubtedly modify product design and
almost certainly reduce holdings of the more volatile asset classes worldwide.
6
Life insurance liabilities are illiquid : no market exists – thus ALM remains a key issue.
Defined benefit pension funds have a different problem. They are becoming effective
liabilities of the sponsoring company and the investment policy being adopted is thus
being passed through to the marginal risk/ return received by shareholders of that
company. In the absence of inflation guarantees, and given the short term nature of profit
reporting under IAS (and the impact of IAS19 in particular) there will be an increasing
imperative for the remaining DB plans to move to less volatile asset classes.
DC pension plans, which are already beginning to dominate institutional investments
(see comment on Australia above), are thus the main likely source of capital market
growth. This growth will be reflected on both life insurance and investment company
statistics in emerging markets, to the extent that these institutions participate in the
supplementary pensions markets. Even here there is a growing tendency to manage
investment risk on behalf of plan members, given the increasing evidence that most
people are incapable of making rational choices in light of their own situations (and are
often under sales pressure in an environment where commissions tend to be correltaed
with asset risk). The current debate as to whether equity markets tend to revert to
equilibrium values is, if anything, also likely to reinforce a more risk averse approach.
The slow emergence of annuity markets will necessitate the development of long term
capital market instruments however these will need to evidence minimum acceptable
degrees of cash flow predictability.
Table 2: Insurer asset allocations by country - 2001
Country
RBC
Countries
Canada
USA
Non RBC
Australia
Czech Republic
Mexico
Poland
Portugal
UK
Institutional Inv’s
as %GDP
Insurers assets
as % GDP
%
Liquids
%
F.I.
%
Equity
%
Other
116
191
29
41
5.1
13.7
65.7
54.4
19.1
29.6
10.1
2.3
130
15
12
10
52
191
41
8
2
5
22
97
8.2
10.6
0.7
28.7
8.3
11.1
31.8
62.4
86.2
57.3
56.0
19.0
58.9
9.4
5.9
10.0
7.7
57.3
1.1
17.6
7.2
4.0
28.0
12.6
Source: OECD Institutional Investor’s Statistical Yearbook 2003
The relatively low equity percentages which apply to life insurers in non RBC7 countries
other than the UK and Australia reflect a combinations of influences. The most
important is probably the lack of development of relevant sections of the capital market.
However governments often also intevene in the investment strategies of institutional
investors, either to sustain chronic deficits or for the purposes of encouraging
infrastructure development and housing. For example as late as the mid 1970s New
7
Risk based capital.
Zealand imposed a 50/30/20 rule on life insurers8. The French government has recently
indicated that it will require long term investors to apply a minimum proportion of their
assets to entrepreneurial activities.
The high Australian and UK equity ratios reflect more flexible liability structures than
apply in countries influenced by Continental contractual forms, and the use of smoothing
techniques by a well entrenched actuarial profession. These techniques are now being
questioned and the equity proportion in the UK has reduced precipitously since 2001. In
Australia a significant proportion of market risk has been transferred to policyholders in
the form of investment linked contracts.
Much of the ‘Other’ category is typically real property, often the only long term
investment available. In some countries this also reflects the primary business interest of
the institution’s principals.
Policy issues and implications:
There is a long history of institutional investors helping to build the real economies of
what are now the industrial countries. Areas of involvement have usually involved
infrastructure, the industrial and agribusiness sectors (generally post the venture capital
stage) and housing. This was typically in a more stable era when governments
intervened more actively at the micro level in the financial sector, and played the primary
roles in physical infrastructure development (see reference to New Zealand above). The
question arises as to what circumstances make such intermediation possible: even in the
EU accession countries there are strict limits on investment in non listed equity
investments by supplementary pension funds. The obvious pre conditions include strong
institutional regulation and supervision and the development of suitably liquid investment
instruments with appropriate credit enhancement (in practice this may mean the
government needs to become an effective guarantor).
However this is happening in a less stable environment in which efficient capital usage
has become much more important to institutional management and boards: in a market
driven environment the nature of their liabilities will increasingly drive the capital needs
and investment policies of the institutional investors.
The challenge then becomes to develop intermediate mechanisms to convert real sector
investments needed to grow economies into assets which meet the various institutions’
ALM and risk capital requirements. The most likely candidates are securitized and
structured instruments. The World Bank Group’s key role would then be to help develop
and support the relevant intermediate institutions and products and the supporting
infrastrucure. Activities could include:
1. Establishing mortgage and commercial debt packagers
8
At least 20% of net funds increase in sovereign debt, at least 30% in sovereign and sub sovereign debt and
at least 50% in sovereign and sub sovereign debt and housing finance.
2. Supporting the setting up of mortgage lenders insurers (possibly with partial
sovereign capital or guarantee)
3. Developing an infrastructure packaging capacity (including sovereign and sub
sovereign instruments)
4. Developing relevant product development and risk management skills within the
institutions
5. Helping to design and install relevant regulatory and supervisory environments
6. Ensuring that suitably rigorous credit rating capacities are in place
7. Establishing appropriate legal infrastructures
Implication for Work Program
Institutional linkages with the real economy provide clear scope for ESW and TA with a
strong development theme. This points to cross sectorial work with PREM to develop
methodologies for assessing the current efficacy of institutional investor - real sector
linkages and the causes of any roadblocks.
From a lending perspective (aside from TA) the main opportunities arise from sectorial
restructuring and recapitalization and sovereign capitalization of professionally managed
intermediaries (can policy development loans be adapted?) such as asset aggregators and
packagers and mortgage lending insurers (with a long term privatization agenda in mind).
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