Insurers’ investments

Ten years after a major financial crisis, the market is faced with new uncertainties, with lingering low interest rates.

For more than a decade now, major insurers and investors in the financial market have been up against a situation where the difference between the duration of assets and liabilities in their balance sheet makes them embark on new risks. In this context, financing strategy plays a key role.

Insurers’ investment typology

Life insurance: The products widely marketed take into account the death risk. Premium calculation and compensation settlements are carried out according to the standardized mortality tables. This fundamental fact provides for good forecasts about life insurers’ investments.

Retirement insurance funds: Their business is close to that of life insurance. The premiums collected are known as they account for a percentage of the salary while the benefits are refunded at retirement age and are equally known.

Non-life insurance: While premium calculation reflects insurer’s exposure to risk, taking into account the latter’s profile and background, the occurrence of an event may exhibit a more arbitrary character. Indeed, potential disasters are harder to foresee in non-life insurance than in life insurance.

Investment strategies, therefore, vary according to the nature of the insurance company, and based on its profile and portfolio. Consequently, life and pension funds insurers are long-term investors with foreseeable liquidity needs. They are attracted by less liquidity assets that they detain over long periods of time. Moreover, we are witnessing an increase in life expectancy: Treasury bonds, mortgages, real estate investments, etc.

Contrarily, non-life insurers detain more liquidity. Indeed, with harder to predict disasters, non-life insurers are in more and more pressing need for liquidity in order to address uncertainties.

Definition of insurers’ investment policy

It is the Top Management of the insurance company that determines investment strategy that is then submitted to the board of directors for approval. The strategy is devised upstream by the actuaries in collaboration with the leading team. It takes into account regular revenues from collected premiums, the type of business underwritten and the particularity of the classes of business on which the insurer has embarked.

The investment strategy includes use requirements for the various investment categories, with each of which having to meet investment needs of the insurance company.

The document that defines investment strategy must indicate:

• Investment principles and the objectives pursued by means of the model used,
• The investment categories authorized and those not authorized,
• Description of investment techniques,
• Description of investment, control and monitoring procedures,
• Description of the distribution of responsibilities and of the skills required

It is noteworthy that thanks to enabling regulations, investment in the environmental and social areas, called “responsible investments”, is getting more and more size in insurers’ investment strategies.

Insurers’ investment portfolios

Aujourd’hui, les portefeuilles d’investissement des sociétés d’assurance sont très exposés aux emprunts souverains des pays les plus développés. Les niveaux historiquement bas des taux d’intérêt depuis près d’une décennie peuvent pousser les assureurs à allouer une part plus large de leurs investissements à des actifs à rendements plus attractifs.

Cette solution peut inclure les marchés actions, l’immobilier, voire la dette émergente, la dette privée, la dette d’infrastructure et les crédits hypothécaires. Certains de ces marchés étant bien moins liquides que les emprunts d’Etat, de nouvelles pressions sur la gestion des actifs des assureurs ne sont pas à exclure. Il va de soi que ces investissements spécifiques requièrent une expertise financière pointue.

Insurers and investment aid tools

There are different tools assisting with the management of insurance company investments.

1- The Markowitz model

Developed in 1952, this model comprises several hypotheses:

• Financial markets are perfect, tax free, transaction cost free. Information flows smoothly and transparently with no restrictions on funding and investments.
• Investors are aversive to risk,
• Investors are not keen on anything except on return estimates and on their portfolio, and on the level of risk inherent to their investments.

According to the Markowitz model, investing insurer builds up its investment portfolio by maximizing portfolio return while minimizing the variance of its returns.

2- Capital Asset Pricing Model (CAPM)

It is another theoretical model that analyzes the relationship between systemic risk and the expected return of financial assets. This model rests on a dual intention:

• Determination of the right price of financial assets according to risk if markets are balanced,
• Determination of investment attractiveness in comparison with the reference price calculated by the model and based on risk free investment rate and risk premium that depends on systemic risk.

It is, therefore, the systemic risk that determines financial asset pricing in Capital Asset Pricing Model.

3- Treynor’s ratio

It quantifies return excess of an asset beyond risk-free rate for each market risk unit. This entails measurement of the difference between the expected portfolio return and risk-free rate divided by systemic risk anticipated by Capital Asset Pricing Model. Portfolio expected return minus risk-free rate for each systemic risk unit determines market’s risk premium.

An investment must be made if Treynor's ratio ishigher than the market risk premium.

4- Sharpe’s ratio

This tool is designed to compare investment opportunities that have different risk levels, disregarding systemic risk but measuring expected return per risk unit.

According to OECD survey conducted within major reinsurance companies, insurers are adopting a wide range of methods for their investment policies:

• Asset allocation depends on optimization of average variance, taking into account taxes and capital costs.
• Liability-based investment techniques take into account the nature of liability elements.
• Allocation of strategic assets is based on an asset-liability management procedure, relying on the optimization of the average variance. This method may be combined with an approach that takes into account maturity of engagements and optimization of venture capital.
• These analyses depend on economic parameters and on fluctuation of interest rates.

Return optimization models highlight different asset allocation strategies resulting in a combination of risks or economic or return and economic value-based capital. The strategy pursued for the allocation of assets is the one that generates important economic capital-economic value ratio.