The Role of Portfolio Management
Portfolio and asset liability management are important for both life and property liability insurance companies. However, the latter face the problem that their liabilities are far more unpredictable than the liabilities of the life insurance companies. For example, given a stable mortality table and other historical data, it is easier to predict the approximate number of death claims, than the approximate number of claims on account of car accidents and fire.
As a consequence of such uncertainty, and perhaps also moral hazard stemming from reinsurance facilities, asset liability manage¬ment of property liability companies in the US has left much to be desired. Hence, a meaningful discUS$ion about the changing nature and role of portfolio management for US's insurance companies is possible only in the context of the experience of its life insurance companies.
Although the role of an insurance policy is significantly different from that of investments, economic agents like households have increasingly viewed insurance contracts as a part of their investment portfolio. This change in perception has not affected much the status of the property ¬liability or non life insurance policies, which are still viewed as plain vanilla insurance contracts that can be used to hedge against unforeseen calamities.
However, the perception about life insurance contracts has perhaps been irrevocably altered, and it has changed the nature of fund management of insurance companies significantly, forcing them to move away from passive portfolio management to active asset liability manage¬ment. The change in perception of the households became apparent during the 1950s, when stock prices rose sharply in the US.
Given the steep increase in the opportunity cost of funds, households shied away from whole life insurance products and opted for term life insurance policies! During the earlier part of a policyholder's life, the premium for a term insurance policy is lower than the premium for a whole life policy.
Hence it was in a (young) household's interest to opt for term insurance, and invest the difference between the whole life premium and term life premium in the equity market. As a consequence, the life insurance companies were forced to think about development of new products that could give the investors returns commensurate with the pins in the stock market.
The immediate impact of the financial volatility on portfolio or asset liability management came by way of a change in the design of the life insurance products. The insurance companies started offering universal life, variable life, and flexible premium variable life products.
These policies bundled insurance coverage with investment opportunities, and allowed policy holders to choose the amount of their annual premium and/ or the nature of the portfolio into which the premium would be invested. Most of these contracts carried guaranteed Minimurn death benefits, but returns over and above that were determined by the inflow of premia and the subsequent investment experience.
Some of the policies could also be forced into expiration if the aforementioned inflow and experience fell below some critical minimum levels. Further, policy loans were offered only at variable rates of interest.
In other words, the policyholders were increas¬ingly co opted into sharing market and interest rate risks with the insurance companies.
As a consequence of these changes, which brought about a bundling of insurance and investment products, portfolio management of life insur¬ance companies today is similar to that of a bank or non bank financial company.
They have to,
(i) look out for arbitrage opportunities in the market place both across markets and over time,
(ii) use value at risk modelling to ensure that their reserves are adequate to absorb market related shocks,
(iii) ensure that there is no mismatch of duration between their assets and liabilities, and
(iv) ensure that the risk return trade off of their portfolios remain at an acceptable level. During the 1980s, the life insurance companies gradually reduced the duration of the fixed income securities in their portfolio, thereby ensuring greater liquidity for their assets.
They also moved away from long term and privately placed debt instruments and increasingly invested in exchange traded financial paper, including mort¬gage backed securities.
However, while the increased liquidity of their portfolios reduced their risk profiles, they also required active management of these portfolios in accordance with the changing liability structures and market conditions. Today, while life insurance companies compete for market share by changing the nature and structure of their products, their viability is critically dependent on the quality of their portfolio and asset¬ liability management.
Portfolio and asset liability management are important for both life and property liability insurance companies. However, the latter face the problem that their liabilities are far more unpredictable than the liabilities of the life insurance companies. For example, given a stable mortality table and other historical data, it is easier to predict the approximate number of death claims, than the approximate number of claims on account of car accidents and fire.
As a consequence of such uncertainty, and perhaps also moral hazard stemming from reinsurance facilities, asset liability manage¬ment of property liability companies in the US has left much to be desired. Hence, a meaningful discUS$ion about the changing nature and role of portfolio management for US's insurance companies is possible only in the context of the experience of its life insurance companies.
Although the role of an insurance policy is significantly different from that of investments, economic agents like households have increasingly viewed insurance contracts as a part of their investment portfolio. This change in perception has not affected much the status of the property ¬liability or non life insurance policies, which are still viewed as plain vanilla insurance contracts that can be used to hedge against unforeseen calamities.
However, the perception about life insurance contracts has perhaps been irrevocably altered, and it has changed the nature of fund management of insurance companies significantly, forcing them to move away from passive portfolio management to active asset liability manage¬ment. The change in perception of the households became apparent during the 1950s, when stock prices rose sharply in the US.
Given the steep increase in the opportunity cost of funds, households shied away from whole life insurance products and opted for term life insurance policies! During the earlier part of a policyholder's life, the premium for a term insurance policy is lower than the premium for a whole life policy.
Hence it was in a (young) household's interest to opt for term insurance, and invest the difference between the whole life premium and term life premium in the equity market. As a consequence, the life insurance companies were forced to think about development of new products that could give the investors returns commensurate with the pins in the stock market.
The immediate impact of the financial volatility on portfolio or asset liability management came by way of a change in the design of the life insurance products. The insurance companies started offering universal life, variable life, and flexible premium variable life products.
These policies bundled insurance coverage with investment opportunities, and allowed policy holders to choose the amount of their annual premium and/ or the nature of the portfolio into which the premium would be invested. Most of these contracts carried guaranteed Minimurn death benefits, but returns over and above that were determined by the inflow of premia and the subsequent investment experience.
Some of the policies could also be forced into expiration if the aforementioned inflow and experience fell below some critical minimum levels. Further, policy loans were offered only at variable rates of interest.
In other words, the policyholders were increas¬ingly co opted into sharing market and interest rate risks with the insurance companies.
As a consequence of these changes, which brought about a bundling of insurance and investment products, portfolio management of life insur¬ance companies today is similar to that of a bank or non bank financial company.
They have to,
(i) look out for arbitrage opportunities in the market place both across markets and over time,
(ii) use value at risk modelling to ensure that their reserves are adequate to absorb market related shocks,
(iii) ensure that there is no mismatch of duration between their assets and liabilities, and
(iv) ensure that the risk return trade off of their portfolios remain at an acceptable level. During the 1980s, the life insurance companies gradually reduced the duration of the fixed income securities in their portfolio, thereby ensuring greater liquidity for their assets.
They also moved away from long term and privately placed debt instruments and increasingly invested in exchange traded financial paper, including mort¬gage backed securities.
However, while the increased liquidity of their portfolios reduced their risk profiles, they also required active management of these portfolios in accordance with the changing liability structures and market conditions. Today, while life insurance companies compete for market share by changing the nature and structure of their products, their viability is critically dependent on the quality of their portfolio and asset¬ liability management.