Management & Regulation
Investing Insurance Funds
R. Vaidyanathan
< E X E C U T I V E
nsurance companies are among
I
the largest institutional
investors in the world. Assets
managed by insurance compa-
nies 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 inci-
dental 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 busi-
ness. It has to be ensured that the insurers must at all
The author is Professor of Finance, IIM Banga/ore.
The Chartered Accountant
S U M M A R Y >
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 under-
writing 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 per-
centage point higher returns in the US and
January 2001

TABLE 1
Life Insurers, Commercial Banks, Mutual Funds,
Pension Plans as Sources of Funds in the US Money
and Capital Markets ($ Billion) . .
1987 1997
Commercial Banks 128 467
Mutual Funds 55 421
Life Insurers Private 95 199
Pension Plans 36 .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 mar-
kets, are directly related to regulatory controls and man-
agement 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 con-
tractual liabilities (e.g. Liabilities under non-profit
policies) are fixed and guaranteed. The non-
contractual 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.

TABLE-2
GIC And Subsidiaries: Financial Performance
(Rs crore)
94-95 95-96 96-97 97-98 98-99
Underwriting profit/losses (-) % -705 -646 -628 -384 -687
Net Premium -14.45 -10.85 -9.33 -5.22 -8.17

January 2001
The Chartered Accountant
 General Insurance Companies: Liabilities of INVESTMENT REGULATION AND MANAGEMENT
general insurance companies are primarily of a short-
Hence, the regulation of investment of insurance com-
term nature. In general insurance business, most
panies need to focus on:
contracts are renewed each year, and claims are
typically settled within a year or two from the date of
..Solvency requirements
Asset valuation regulation
incident. Since the contracts are subject to annual
review, prospect of inflation substantially increasing
.Minimum percentage of the fund to be invested in
the liabilities is fairly remote, and hence, funds need
not be invested in assets of real nature. Liquidity (of
.
certain asset categories
Restriction on the maximum amount of investment in
certain classes of assets
investments) can be an over-riding consideration for
general insurance companies with unfavourable
. Restriction on the percentage of funds that can be
invested in any one company/industry
underwriting experience. For instance the underwriting
experience in the Indian context, as already indicated is
.Treating some assets as inadmissible for valuation
purposes
provided in Table 2.
Compulsory coverage of technical commitments by
Pension funds: In respect of defined benefit
assets specified by the regulatory authority is a feature
pension scheme, the liability structure will be primarily
in many developing countries. The regulator seeks to
influenced by the age profile of the scheme
maintain the solvency of the concern and also ensure
membership. A final salary scheme with predominantly
that the technical reserves, which are considered as part
young members will have a large proportion of its
of the national savings, are invested in socially relevant
liabilities denominated in "real" terms: On the other
or priority sectors of the economy.
hand a mature pension scheme dominated by
pensioners will have a substantial proportion of its
liabilities defined in "nominal" terms. The liability THE REGULATORY FRAMEWORK
structure directly influences the asset allocation
Broadly there are two regulatory models governing
decision. A final salary scheme comprising mostly
investment policies of insurance companies and
young members will have an investment portfolio tilted
pension funds-the Prescriptive Model and the Prudent-
heavily in favour of equities. A very mature pension
Man Model. The Prescriptive Model is one where the
scheme will carry a near 100% fixed income oriented
asset allocation decisions of these institutional
investment portfolio. The liability structure also indi-
investors are dictated by a mandated investment
rectly influences the asset structure because it has a
pattern. This is followed in countries like India,
bearing on factors such as liquidity and marketability
Canada, Italy, Japan and South Korea. On the other
of investments.
hand, the Prudent-Man Model is one where there is no
In the case of a defined contribution scheme, the
mandated investment pattern, but "eligible assets" and
liability of the scheme at any point is equal to the value
"admissibility limits" must back the prescribed
of the investment portfolio of the scheme. Therefore it
minimum solvency related to eligible assets. This
can be said that the liability structure does not impact
model indirectly influences the asset allocation
the asset allocation decision. However, if the defined
decisions of the insurance companies and pension
contribution scheme is based on a set of target pension
funds. This model is adopted in countries such as the
benefits, the asset allocation decision will be guided by
US, UK, France and Spain.
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 INTERNATIONAL TRENDS IN REGULATION
strategy involves constructing and maintaining an Most foreign countries have regulations that cover the
investment portfolio heavily weighted in favour of assets of the insurer. But the extent to which these regu-
equities up to, say, five years prior to the retirement lations seek to control the assets of the insurance company,
age, and gradually shifting into fixed income securities differ from country to country. Regulations are set on the
closer to the retirement age. This strategy has been basis of the economic environment prevailing in the
found to be quite effective in addressing risks such as country. These regulations could involve restrictions being
inflation risk and capital risk faced by the members of placed on the maximum or minimum to be invested in any
a defined contribution scheme. particular asset, restrictions on the

The Chartered Accountant

January 2001
 company can be separated into two categories. The
accounts are classified primarily according to the nature
of the liabilities for which the assets are being invested.
TABLE -3 These two categories are:
?? Assets supporting the insurer's General
Growth in General Account, Separate account and
Account
the total assets of the US Life Insurance ?? Assets supporting Separate Accounts
Companies ($ millions) Assets that are used to support contractual obligations
providing for guaranteed, fixed benefit payments are
1986 1997 normally held in the company's General Account. Other
Separate Account 109 736 invested assets, used to support the liabilities associated
General Account 829 1843 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
percentage that can be invested in any particular industry and named Separate Account. A Separate Account is held
localisation of investments to name a few. separately from all other assets. These accounts were
first used by US life insurance companies in connection
us with their pension business in the early 1960s.
The investment activities of the insurance companies in State laws provide that assets in appropriate
the US are governed by the State Insurance Law and Separate Accounts may be invested without regard to
Regulations. Though these laws are state specific there the restrictions, which are placed on the General
are commonalties because of the generic nature of the Account investments. Hence a separate account
problems and the role of the National Association of portfolio may comprise of only common stocks, only
Insurance Commissioners (NAIC) and the requirement bonds, only mortgages or any combination of these and
that a foreign insurer licensed to do business in the state, other investments. Nearly 25% of all assets of US life
must comply with the state law. Investment regulations insurers are held in Separate Accounts, (see table 3).
specify the following: Table 3 provides the growth in General Account,
?? The types of investments that are eligible (bonds, Separate Accounts and Total Assets of US life insurers.
preferred mortgages and common stocks etc') The greater growth seen in Separate compared to
?? The minimum quality criteria for individual "invest- General Accounts is due to the higher demand for
ments within the eligible categories. variable products.
?? Commercial mortgages are subject to 75% loan-to-
value limit.
Mix Of Assets And Asset Classes
?? Common stock up to a limit of 1 0% and real estate
US life insurance companies hold and manage assets of
up to 20%.
more than $ 2.6 trillion. The largest investment category
?? The state law also specifies asset valuation. The state
consists of corporate bonds (more than 40%) followed
law also mentions the method of valuation i.e., bonds are
by equity holdings (23%). Real estate mortgage loans
valued on an amortised basis, and, the stocks are valued
account for 8% and treasury and federal securities
at cost or market; price, whichever is lower.
account for another 15%. Investment in securities of
?? Certain types of assets are not admitted for the pur-
pose of state regulation. These typically include office
furniture, overdue balances from agents' etc.
?? All classes of assets including real estate are TABLE-4
exposed to reserving rules.
?? For the purpose of investment regulation, a Distribution of assets of US Life
company's capitalisation is measured by either networth Insurers ( 1997 )
to total assets or ratio of capital to risk weighted assets.
?? As regards the life insurers, they invest in the debt Corporate Bonds 41.1 0%
and equity issues of types of companies and they also Stocks 23.20%
make direct investment in mortgage loans for real estate Miscellaneous 6.50%
like office buildings, apartment buildings, and shopping Policy Loans 4.10%
arcades. Besides, they are also major buyers of Government Bonds 15.20%
Government. Securities. Real Estate 1.80%
The total investment portfolio of a life insurance Mortgages' 8.10%

January 2001
The Chartered Accountant

TABLE-5
US Life Insurers' General Account Assets Mix
1986 and 1997
1986 1997
Bonds 50 70
Stocks 10
Mortgages and Real Estate 25
5
15
Policy Loans
Miscellaneous Assets
5
10
5
5
other countries' governments and international agen-
cies, have always been small (1.5% of total assets).
Investments in both long and short-term non-US cor-
porate 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 sup-
port liabilities associated with investment risk pass-
through products or lines of businesses such as variable
It includes refinements intended to address the asset
quality concerns that have developed in the industry.
The most significant new provision permits the sub-
jective 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 regu-
latory 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 ver-
sion)".
. 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.

.
annuities, variable life insurance and pension products.
In these products, the investment risk has been trans-
UK
UK has probably the most liberal regimes.
ferred to the customers.
. They may be invested without regard to state laws,
. No specific rules indicating the assets in which
investments can be made.
regulating the investment of General Account assets.
. Investment managers are free to allocate assets
..Regulations lay down rules regarding
Type of assets:

.
among any investments available in the market.
Pension customers may and frequently do participate
in the allocation decisions. Table 6 shows the distribu- TABLE - 6
tion of separate account assets of US life insurers Distribution of US Life Insurers' Separate
during 1997. We find that the corporate stocks Account Assets (1997)
constitute more than 70% of the assets.
. Separate account assets have also grown from 13% to
almost 30% of total assets.
Corporate Stocks 70.60%
Mortgage Loans and Real Estate 2.50%
In 1996, the NAIC adopted a new version of its Policy Loans 0.30%
1992 model investment law titled "Investments of Miscellaneous Assets 9.20%
Insurers Model Act (defined limits version)", similar in Bonds 17.40%
structure to the current regulatory scheme.

The Chartered Accountant . January 2001

 TABLE 7 . 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
Companies* specific category limits, legislative constraints,
desired risk/reward balance, composition of
UK equities 39% liabilities and policyholder's reasonable
expectations
UK fixed interest securities
Index Linked Gilts
Overseas Equities
23%
2%
11 %
.. Special attention must be paid to derivatives
Appropriate resources must be allocated to
these tasks
Overseas fixed interest securities
Property
3%
9% . The Board must discuss all these matters regu-
Cash
Units of Unit Trusts
3%
7% .
larly so as to be satisfied of compliance
Appointed actuaries have an important role to
play in terms of
Others 3%
* Figures based on Financial Statistics 1995; . Set up specific reserves for possible future
changes in the value of the assets
HMSO
. Ensure that the investment policy followed by

.. Extent to which they can be invested in.

directors is in consonance with the nature and the term
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.
Prudential Guidance Note issued by DTI (which was
policyholders.
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.
Appropriately diversified and adequately spread
assets.
companies in UK.

.. Matching and localisation requirements

Avoidance of speculative trading in financial
TABLE- 8
Asset Allocation Pattern of UK general
instruments
..Application of assets for long term business and
The observance of prudential guidance notes
Insurance Companies (excluding long term
business)*

.The board should also be aware of the responsibility

of the appointed actuary, in particular the duty to advise
Type of Investment
UK Equities
(%)
16
about an appropriate investment policy for a long term UK Fixed Interest Securities 28
fund and should ensure that the actuary is in a position Index Linked Gilts 1
Overseas Equities 4
.
to discharge those responsibilities.
Management control and information systems should
be established to carry out the strategy to enable the
Overseas
Securities
Fixed Interest
11
Property 3
.
board to monitor its progress
The board of directors should receive reports at an
appropriate frequency with appropriate details as to
Cash &
Others**
Short Term Assets
27
10

*Compiled from Financial Statistics, 1995,

.
investment activities and controls .
The credit worthiness of counterparts (including rein-
surers) should be regularly verified and systems must be
HMSO
**This category includes overseas loans and
established to monitor aggregate exposure and to set mortgages, British Government Foreign Currency
lower limits if appropriate Securities and direct investment.

The Chartered Accountant January 2001

 TABLE-9 covers are required. Foreign investment is permitted up
to the amount of commitments' contracted in foreign
Asset Allocation Pattern for UK Pension Fund currencies, if any. .
Type of Investment %
UK Equities 51 Middle East Countries
UK Fixed Interest Securities 7 In the Middle-East countries, the regulations of insur-
Overseas Equities 22 ance investments vary. In some of these countries, the
Overseas Fixed Interest respective supervisory authority is empowered to issue
Securities 3 rules concerning the valuation of funds allocated to
UK property 5 cover mathematical reserves. In others, the systems in
Index Linked Gilts 5 force are not confined to insurance concerns - they are
Cash & Deposits 5 subject to the general laws laid down for all
Others 2 investments, and require the valuation of assets to be
Source: Pension Funds and their Advisers, 1998 supervised by the auditors.

Table -9 presents an average asset allocation France

pattern for UK Pension Funds. . The assets have to back the technical and mathemati-
We note that substantial allocation has been done
for equities in the case of the pension funds and these .
cal reserves.
The assets in the same currency upto 80% should
funds play an important role in the capital market.
Given the nature of asset liability structure it is natural .
back liabilities in one currency. .
The allocation of regulated assets will have the fol-
lowing cap condition:
that larger focus is on equity investment by the pension
funds. ..65% for Stocks;

Japan .40% for Real Estate;

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
10% for Loans.
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

.
manner:
Japanese Government. Bonds, Local Government.
Bonds, Debentures or Stocks. .
Equities
..
Investment Trusts

. Government. Bonds, Debentures or Stocks of foreign

countries.
..
Property
Property Investment Trusts

..Secured Loan.
Foreign Bonds and Shares.

..
Real Estate.
Loans according to policy conditions.
Postal Savings or Bank Deposits.
INDIAN SCENARIO

..
Money Trust or Security Trust in Companies.
Any other manner approved by the Ministry of
Finance.
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
Currently, insurance companies and approved pension
funds in India are subject to the prescriptive model. The
mandated investment patterns applicable to these insti-
tutional 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

The Chartered Accountant January 2001.

 ..

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

The Chartered. Accountant January 2001