Portfolio Management Unit – II Session No. 16 Topic: Managing Portfolios by Insurance Industry Session Plan • Recap the Previous Session • • • • • 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 • 1. 2. 3. 4. 5. 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 • • • • • 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?