Wednesday, September 28, 2011

MANAGING INVESTMENTS

A portfolio is a collection of assets assembled for the purpose of meeting a defined set of financial goals.

Organization of Investment Operations


A life insurance company’s investment operations are overseen by the company’s chief investment officer, who directs a team of portfolio managers. The insurer’s investments are separated into portfolios by asset type-stocks, bonds, mortgages and real estate-and a portfolio manager assigned to each portfolio makes investment decisions according to the company’s general investment guidelines.

Many insurance companies have found that they need a close link between portfolio managers and actuaries to achieve asset liability management goals. The person responsible for this link is the asset liability manager. Also called an asset manager, monitors the investment related cash inflows and cash outflows for a specific line of the insurer’s business and makes sure sufficient funds available when needed to support that line.

In addition to Chief Investment Officer, asset manager, portfolio managers other employees in the investment department may include
Investment analysts, who conduct research into specific investment opportunities.
Economists, who forecast and track economic trends.
Traders, who buy and sell assets for the portfolios.

Establishing an Investment Policy


Approved by the company’s board of directors, the investment policy typically incorporates the following factors:

  • The insurer’s investment objectives
  • The types of investments needed to achieve the insurer’s investment objectives.
  • Minimum standards for the safety of the principal invested
  • The types of risks that investment staff can and cannot take in making investments.
  • The maximum amount of money that each level of investment staff can authorize for an investment without having to seek approval from a higher level of authority within the company.
  • Applicable national, state, and provincial regulations that constrain the insurer’s investment activities.

Investment Department Activities


The day-to-day activities in the investment department are based on the operational plans established by the chief investment officer, the asset/liability managers, and the portfolio managers. When evaluating a specific investment, a portfolio manager generally considers the following factors:
  • The investment’s cash flow patterns.
  • The investment’s expected rate of return.
  • The risk characteristics of the investment.
  • The liquidity of the investment.
  • General economic conditions, such as expected movements in interest rates and the expected inflation rate.
  • Regulatory requirements that constrain the insurer’s investment activities.

A capital gain is the amount by which an asset’s selling price exceeds its purchase price.

The relationship between risk and return can be expressed in the following way. All other factors being equal, the higher the risk associated with an investment, the greater the potential return on the investment. Similarly, the lower the risk associated with an investment, the lower its potential return. The interplay between risk and return is known as the risk-return tradeoff.

Inflation is the prolonged increase in the average level of prices in the economy.

In the context of investments, diversification is a technique for spreading risk by investing in different assets with different levels of risk.

Regulation of Insurer Investments


These regulatory requirements are designed to [1] require insurers to exhibit reasonable behavior with respect to prudent diversification of their investment portfolios and [2] protect consumers from the threat of insurer insolvency as a result of an insurer’s taking too much risk. Regulatory requirements for investments are typically different for an insurer’s general account and its separate account.


A general account is an account composed of assets that support the life insurer’s contractual obligations for guaranteed products the insurer has issued.

A separate account, also called a segregated fund in some countries, is an account composed of assets that support the liabilities associated with the variable products.

In the US, life insurers must comply with state requirements that govern their general account investments. Such regulatory requirements define which assets an insurer may include when reporting its admitted assets. Each state also requires insurers to follow specified safety guidelines when selecting their general account investments. Such regulatory requirements take two general forms:

  • Most states impose quantitative limitations on the amount of each type of asset an insurer may treat as admitted assets.
  • A few states impose a prudent person approach that, rather than placing quantitative limits on insurer investments.

Insurance Company Investments


A debt asset represents the investor’s loan of funds to the debt insurer in exchange for the promised repayment of the principal loaned and the payment of the interest on principal loaned.

An equity asset represents the investor’s ownership or share of ownership
in an asset such as a business or a piece of property. Common stock is an example.

Most assets held by Life Insurance Company can be classified as securities.

New Issues of Securities

In a public offering, the security issuer makes a new security available for sale to the public. The issuing firm must register with the appropriate government agency such as SEC in the US. The security registration document requires information about the type of security being offered and the issuing company’s financial condition, management, industry competition and experience.

Private placements have come a preferred way for insurers and other large institutional investors to purchase new issues of securities. A private placement is a method of issuing securities in which the security is sold directly from the issuer to a limited no. of investors, typically institutional investors.


Previously issued Securities

A securities exchange is a market in which buyers and sellers of securities – or their agents / brokers – meet in one location to conduct trades. An over the counter OTC market is a method of selling securities in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities.

Bonds

 A bond is a security that represents a debt that the borrower- the issuer of bond-owes to the bondholder-the investor who owns the bond. The amount owed on the bond’s maturity date is known as bond’s face value, maturity value. In addition to repaying a bond’s face value, the bond insurer is usually obligated to make periodic interest payments known as coupon payments because the amount of the interest payments is based on an interest rate, known as the coupon rate, specified on the bond.

 

Bond Risk & Return Characteristics


Several characteristics of a bond determine the degree of risk it presents to the purchaser. The riskier the bond, the higher the coupon rate the bond has.

Term to Maturity A bond’s term to maturity is one of the most important factors in determining its balance of risk n return. Bonds with long term to maturity are more susceptible to interest-rate risk.

Default risk is the risk that the issuer of a bond will be unable to make interest payments when these payments are due or to pay the face value of a bond when the bond matures. Bond ratings help insurance companies and other bond purchasers determine the creditworthiness of bond insurers and the default risk of their bonds. Bonds that are rated in the highest categories and that have the lowest risk of default are known as investment-grade bonds. Bonds that are rated in the categories below investment grade are known as high-yield bonds or junk bonds.


Call provision Some bonds contain this provision that states the conditions under which the bond issuer has the right to require the bondholder to sell the bond back to the issuer at a date earlier than the maturity date.


Convertibility a convertible bond can be exchanged for shares of the issuing company’s common stock at the option of the bondholder.

Collateral Bonds may be either secured or unsecured, depending upon whether the bond is backed by collateral-assets that are pledged as security for a loan until the debt obligation is satisfied.


Types of Bonds

  • Corporate Bonds are issued by corporations, typically very large corporations.
  • Government bonds are issued by national, state, provincial, or city governments to generate funds.

Stocks are riskier than bonds because
  • Cash-flow characteristics associated with stocks are more variable.
  • Amount of cash dividend can be changed over time.
  • Stock prices tend to fluctuate much more than bond prices.
  • Stockholders have a lower priority claim than do bondholders on the issuing company’s assets if the company goes out of business.

A mortgage is a loan, typically a long-term loan, secured by a pledge of specified real estate. The borrower pays off the loan through the process of amortization, which is the reduction of a debt by regular payments of principal and interest that result in full payment of the debt by the maturity date.


Most insurers today also invest in residential mortgages. Rather than holding many individual mortgage loans, however insurers participate in the residential mortgage market by buying mortgage-backed bonds, known as collateralized mortgage obligations (CMOs), which are bonds secured by a pool of residential mortgage loans.

Insurers invest in real estate by participating in a sale-and-leaseback transaction, under which the owner of a building sells the building to an investor but immediately leases back the building from the investor. The individual or organization that leases the building from the insurer is known as lessee and the insurer lessor.

Categorizing investment strategy by the amount of trading done in a portfolio can be done in
Buy-and-hold strategy, investment department staff carefully select debt securities and expect to hold them until they mature, are prepaid or default.


Active Management Strategy, investment department staff view any investment in the portfolio as potentially tradable, if trading the investment would improve the portfolio’s performance.

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