Institutional Investors: Life Insurance Companies

When it comes to managing institutional accounts, parts of the process are easy to understand, and parts are very specific. Take life insurance companies as an example. Think through the financial risks that insurers face. Of course there's equity-market risk, and that's significant, no question about it. But there's also another unique risk that combines basic financial elements with the unique cash value features that life insurance contracts have. What common financial risk might this be?

No. Credit risk is a part of overall financial risk, but insurers are holding cash reserves, not depending on them.

Not quite. Systematic risk impacts all markets, so it's not a unique risk.

Right you are. Along with the cash value in ordinary life insurance, interest rate risk is a big part of managing insurance portfolios because insurance contracts (such as annuities) are interest sensitive. Put yourself in the shoes of a policyholder who has accumulated a cash value in a policy. If the policy contract specifies a certain loan rate for the life of the contract, interest rate risk is embedded within that policy. So what would be best to do to the insurance policy's cash value?

That's not a good idea. That's just going to pay premiums.

Right! If you're the policyholder, you'd withdraw that cash value at lower loan rates and invest in higher interest rates. It's simple arbitrage, and it's an example of __disintermediation__, or the withdraw of funds from a bank or insurance company to invest them directly.

Not quite. Interest rate risk doesn't involve equities.

Another disintermediation interest rate risk is that policyholders will borrow against their accumulated cash value life insurance policies. That's not a good situation for the insurance company! In response to this problem, insurance companies have raised the rates of interest credited to a policyholder's reserve account. These are called __credited rates__. Consider what this development has done to life insurance companies. This has increased not only the amount of interest that companies pay, but also competition (dramatically). Now life insurers are more interest rate sensitive than ever and have shorter liability duration because policyholders are shopping around for the best rates. How do you think this increased competition has impacted how a life insurer must calculate a policy premium?

That's not accurate. Premiums aren't going to be cheaper with great unknowns factored in.

Not quite. Interest rates don't really affect the probability of dying.

Precisely. Surrender rates are going to be harder to forecast because those interest rate forecasts change so much. This uncertainty makes policy pricing much more difficult, leading insurance companies to spend lots of time trying to accurately forecast surrender rates. Competition has also created new policy types, like universal, variable, and variable universal, which were meant to respond to the disintermediation of individuals buying term policies and investing the difference in premium values. These policies allow holders to buy varying amounts of life protection, along with receiving rates at competitive market rates.

From this discussion of disintermediation, it should be clear that insurers must have competitive rates of return on their policies to attract new business, and this competitive rate environment has impacted their ability to take risk through the reduction in the duration of their portfolios. In general, the primary goal of an insurer's portfolio is to fund future benefits and claims that belong to policyholders. Given this relationship, portfolio risk is monitored closely because the insurer must be able to meet these future needs. In reality, then, an insurer's portfolio resembles another type of account. Which account do you think that is?

Yes, that's right. An insurer's portfolio resembles a trust account, since there are beneficiaries that must be factored into the management of the account. Insurance companies are therefore highly sensitive to losing principal or experiencing any decrease in income. And as you can imagine, regulatory bodies are also concerned with the portfolios of insurance companies. In the United States, insurers are required to maintain an asset valuation service, which is a reserve that incorporates calculations based on the insurer's assets to find the maximum amount required in the reserve. This amount then has a large safety buffer to absorb investment losses, but it can actually be written down as an asset value's increase because a higher margin of safety would be required.

No. Individual accounts are owned by the individual.

Not so. A tax-deferred account benefits the account owner.

Recently, global insurance regulators have introduced risk-based capital requirements that ensure companies have surpluses that cover their risk exposures for both assets and liabilities. Truth be told, it's really part of a larger push to examine how assets and liabilities interact with each other on a per-company basis. From the regulator's perspective, this means that regulators estimate whether surpluses are sufficient to cover liabilities and assets. But they'll need to be careful with this approach, as accounting rules mark-to-market asset values, but not liabilities, so there can be mismatches on the balance sheet.

For insurers, the asset/liability relationship is crucial to understanding all the various factors of risk. As you know, interest rate risk is a big part of the portfolio management process, and it can be broken down into two parts. __Valuation concerns__ represent the fact that a duration mismatch can occur between assets and liabilities. In particular, if interest rates are rising, a longer duration of assets versus liabilities can result in the write-down of a surplus. There's also __reinvestment risk__, which is the risk of investing income or principal at a lower rate than the original rate or coupon. For example, an annuity contract that pays out at maturity will need to be reinvested over the course of the policy. What would interest rates need to do for the insurance company to benefit from reinvestment risk?

Nice try, but no. That's going to hurt the insurance company.

No. The insurance company wouldn't benefit from equal rates.

Indeed. If interest rates rise, then the insurer can reinvest at higher rates and earn more return, thereby benefiting. For these reasons, risk objectives that specifically address interest rate risk and the mismatch of assets and liabilities are typical. In addition to interest rate increases, insurers also take credit risk when investing in bonds, as well as cash flow risk in the anticipation of receiving cash flows on time so that the projected reinvestment rate can be earned. Compounding is a huge part of an insurer's model, so not receiving or having delayed payments is a big problem.

To summarize: [[summary]]

Credit risk

Systematic risk

Interest rate risk

Deposit more funds to grow the cash value

Withdraw the funds and invest in higher rates

Withdraw the cash value and invest in equities

Premiums are much cheaper than before

Mortality tables are much more difficult to forecast

Surrender rates are much more difficult to forecast

Trust

Individual

Tax-deferred

Rise

Decline

Remain flat

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