Portfolio Management
Unit – II
Session No. 16
Topic: Managing Portfolios by Insurance Industry
Session Plan
• Recap the Previous Session
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Insurance Industry
Categories
Types of Policies
Investment Setting
Summarizing and Q & A
THE INSURANCE INDUSTRY
• The economic significance of the insurance industry lies in its unique role as
an absorber of personal and business risks.
• By providing financial protection, the industry plays a key role in a country’s
economic growth and development.
• The insurance industry’s traditional investment practices have been
characterized as conservative. As we will discuss later, however,
• Insurers have shown increasing risk tolerance in recent years.
THE INSURANCE INDUSTRY
• The insurance industry is complex but can be divided into two broad product
categories:
• Life insurance
• General insurance
– Health insurance, and
– Property and Liability insurance.
THE INSURANCE INDUSTRY
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Policy Types:
Term life – Period of policy is specific
Whole life
Universal life
Variable life
Others
THE INSURANCE INDUSTRY
• Life Insurance Companies: Background and Investment Setting
• Exposure to interest rate–related risk is one major characteristic of life
insurers’ investment setting.
• Besides fixed-income portfolio gains and losses related to interest rate
changes, many life insurance company liabilities such as annuity contracts are
interest rate sensitive.
• In addition, insurers also face the risk of disintermediation, which often
becomes acute when interest rates are high.
THE INSURANCE INDUSTRY
1. Risk Objectives
• An insurance company’s primary investment objective is to fund future
policyholder benefits and claims.
• Because of the economic importance of the insurance industry, the investment
portfolio of an insurer (life or non–life) is looked upon from a public policy
viewpoint as a quasi-trust fund.
• Accordingly, conservative fiduciary principles limit the risk tolerance of
an insurance company investment portfolio.
• Confidence in an insurance company’s ability to pay benefits as they come
due is a crucial element in the economy’s financial foundation.
• Therefore, insurance companies are sensitive to the risk of any significant
chance of principal loss or any significant interruption of investment income.
THE INSURANCE INDUSTRY
• 1. Risk Objectives …
• The two aspects of interest rate risk are valuation concerns and
reinvestment risk.
– Valuation concerns: In a period of changing interest rates, a mismatch
between the duration of an insurance company’s assets and that of its
liabilities can lead to erosion of surplus.
– Reinvestment risk: is defined as the risk of reinvesting coupon income or
principal at a rate less than the original coupon or purchase rate.
• Asset/liability management (ALM) is the foundation for controlling both
interest rate risk and liquidity for a life insurance company
THE INSURANCE INDUSTRY
• 2. Return Objectives
• A life insurance company’s return requirements have been specified primarily
by the rates that actuaries use to determine policyholder reserves that is,
accumulation rates for the funds held by the company for future
disbursement.
• The rate either continues as initially specified for the life of the contract or
may change to reflect the company’s actual investment experience, according
to the contract terms.
• Interest is then credited to the reserve account at the specified rate; this
rate can thus be defined as the minimum return requirement.
• Life insurance companies need to grow surplus to support expanding business
volume.
• Life companies establish return objectives for each of these classes
(Common stocks, equity investments in real estate, and private equity) of
equity investments to reflect historical and expected returns.
THE INSURANCE INDUSTRY
• Liquidity Requirements
• Traditionally, life insurance companies have been characterized as needing
minimal liquidity.
• The need to liquidate assets has been negligible, reflecting the growing
volume of business, the longer-term nature of liabilities, and the rollover in
portfolio assets from maturing securities and other forms of principal
payments.
• However, volatile interest rate environments and the ever-increasing
importance of annuity products require that life companies pay close attention
to their liquidity requirements.
THE INSURANCE INDUSTRY
• Time Horizon
• Life insurance companies have long been considered the classic long-term
investor.
• Traditionally, portfolio return objectives have been evaluated within the
context of holding periods as long as 20 to 40 years.
• Most life insurance companies have traditionally sought long-term maturities
for bond and mortgage investments.
• As a result of portfolio segmentation, life insurers may establish relatively
shorter time horizons for some portfolio segments (e.g., group annuities).
THE INSURANCE INDUSTRY
• Tax Concerns
• Unlike pension funds and endowments, insurance companies are tax-paying
rather than wholly or partially tax-exempt investors.
• As commercial enterprises, they are subject to income, capital gains, and other
types of taxes in the countries where they operate.
• The types and application of taxes differ by country, but in all cases, taxes
mean that insurance companies must focus on after-tax returns in their
investment activities.
THE INSURANCE INDUSTRY
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Legal and Regulatory Factors
Insurance is a heavily regulated industry.
In India, Separate Acts are there for Life Insurance and General Insurance
IRDA regulating the operational functions of Insurance Industry in India.
In summary, regulation has a profound effect on both the risk and return
aspects of a life insurance company portfolio, primarily because it constrains
two critical aspects of portfolio management
– asset allocation and
– the universe of eligible investments.
THE INSURANCE INDUSTRY
• Unique Circumstances
• Each insurance company, whether life or non–life, may have unique
circumstances attributable to factors other than the insurance products it
provides.
• The company’s size and the sufficiency of its surplus position are among
the considerations influencing portfolio policy
Summarizing
• What is the role of Insurance Industry in risk absorption?
• How the Insurance Industry supports for economic growth and
development?
• Explain the different types of insurance policies with its unique features.
• What is reinvestment?
• What is the difference between net interest spread & Interest credited to
policyholders ?
• Why the rising interest rates affect the insurance industry?
• Why life insurance companies have traditionally segmented portfolios?
• What kind of tax focused by insurance companies in investment
activities?