Reading 13 Managing Institutional Investor Portfolios Flashcards
Cash balance plan
A cash balance plan is a defined-benefit plan whose benefits are displayed in individual recordkeeping accounts. These accounts show the participant the current value of his or her accrued benefit and facilitate portability to a new plan.
Time Horizon for endowments
In principle, endowment time horizons are extremely long term because of the objective of maintaining purchasing power in perpetuity.
Projected benefit obligation (PBO)
Projected benefit obligation (PBO). The PBO stops the accumulated service in the same manner as the ABO but projects future compensation increases if the benefits are defined as being tied to a quantity such as final average pay. The PBO thus includes the impact of expected compensation increases and is a reasonable measure of the pension liability for a going concern that does not anticipate terminating its DB plan. Funding status is usually computed with respect to the PBO.
Time Horizon of banks
A bank’s time horizon for its securities portfolio reflects its need to manage interest rate risk while earning a positive return on invested capital. A bank’s liability structure typically reflects an overall shorter maturity than its loan portfolio, placing a risk management constraint on the time horizon length for its securities portfolio. This time horizon generally falls in the three- to seven-year range (intermediate term).
Disintermediation
Disintermediation. In the United States, on four different occasions in the past 40 years (1966, 1970, 1974, and 1979–1981), inflation and high interest rates have forced life insurance companies to take measures to accommodate extraordinary net cash outflows. Initially, policy loan drains in conjunction with heavy forward commitment positions forced some remedial but temporary changes in investment strategies. Likewise, the trend of policy surrenders caused 1) actuaries to reevaluate and reduce their estimates of the duration of liabilities and 2) portfolio managers to reduce the average duration of the portfolio and in some cases add to liquidity reserves.
In a period of rising interest rates, a mismatch between the duration of an insurance company’s assets and its liabilities can create a net loss if the assets’ duration exceeds that of the liabilities.
Legal and Regulatory Factors for life insurers
- Insurance is a heavily regulated industry.
- Important concepts related to regulatory and legal considerations include eligible investments, the prudent investor rule, and valuation methods.
- Eligible investments. Insurance laws determine the classes of assets eligible for investment and may specify the quality standards for each asset class. In the United States, for example, many states’ insurance laws require that for a bond issue to be eligible for investment, its interest coverage ratio (earnings plus interest divided by interest) must meet minimum standards over a specified time period (e.g., 1.5 times coverage over each of the past five years) or minimum credit ratings. Generally, regulations specify the percentage of an insurance company’s assets that may be invested in a specific class of eligible assets. For example, in the United States, most states limit the value (at cost) of life companies’ common stock holdings to no more than 20 percent of total admitted assets. Non-US investments are also limited to some extent as a percentage of admitted assets in most states.
- Prudent investor rule. Although the scope of regulation is extensive, it is important to note that the prudent investor concept has been adopted in some US states. Replacing traditional “laundry lists” of approved investments with prudent investor logic simplifies the regulatory process and allows life insurance companies much needed flexibility to keep up with the ever-changing array of investment alternatives. New York’s leadership in this area is important because, traditionally, regulations of this state have been the model for insurance regulation in the United States. Despite a major effort in the mid-1990s, however, no model law or universal investment standards have been adopted by all US states.
- Valuation methods. In the European Union, International Accounting Standards specify a set of valuation procedures. In the United States, uniform valuation methods are established and administered by the NAIC. In fact, the NAIC’s Security Valuation Book, published at the end of each year, compiles the values or valuation bases to be used by insurance companies for portfolio securities. This book is the source of the valuation data listed in Schedule D of the annual statement that each company files with the insurance departments of the states in which it operates. Schedule D is an inventory of all bond and stock holdings at year-end and a recap of the year’s transactions.
Pension fund, plan sponsor (definitions)
Pension funds contain assets that are set aside to support a promise of retirement income. Generally, that promise is made by some enterprise or organization—such as a business, labor union, municipal or state government, or not-for-profit organization—that sets up the pension plan. This organization is referred to as the plan sponsor.
Legal and Regulatory Factors for non-life insurers
- Although the insurance industry in general is heavily regulated, casualty company investment regulation is relatively permissive. On the one hand, classes of eligible assets and quality standards for each class are specified just as they are for life companies.
- A casualty company is not required to maintain an asset valuation reserve. In essence, then, the surplus of a casualty company reflects the full impact of increases and decreases in the market value of stocks. The United States, however, has recently established risk-based capital regulations for the casualty industry. US risk-based capital regulations for casualty insurers specify the minimum amount of capital that an insurer must hold as a function of the size and degree of the asset risk, credit risk, underwriting risk, and off-balance sheet risk that the insurer takes.
Return Objectives for DB plan
A DB pension plan’s broad return objective is to achieve returns that adequately fund its pension liabilities on an inflation-adjusted basis.
For a DB pension plan, the return requirement (in the sense of the return the plan needs to achieve on average) depends on a number of factors, including the current funded status of the plan and pension contributions in relation to the accrual of pension benefits.
For a fully funded pension plan, the portfolio manager should determine the return requirement beginning with the discount rate used to calculate the present value of plan liabilities.
Legal and Regulatory Factors of banks
- Regulations place restrictions on banks’ holdings of common shares and below-investment-grade risk fixed-income securities. To meet legal reserve and pledging requirements banks may need to hold substantial amounts of short-term government securities.
- Risk-based capital (RBC) regulations are a major regulatory development worldwide affecting banks’ risk-taking incentives. RBC requirements restrain bank risk-taking by linking the formula for required capital to the credit risk of the bank’s assets, both on and off balance sheet.
Factors Affecting Risk Tolerance and Risk Objectives of DB Plans
1. Plan status
- Variable: Plan funded status (surplus or deficit)
- Explanation: Higher pension surplus or higher funded status implies greater risk tolerance.
2. Sponsor financial status and profitability
- Variable: Debt to total assets, current and expected profitability
- Explanation: Lower debt ratios and higher current and expected profitability imply greater risk tolerance.
3. Sponsor and pension fund common risk exposures
- Variable: Correlation of sponsor operating results with pension asset returns
- Explanation: The lower the correlation, the greater risk tolerance, all else equal.
4. Plan features
- Variable: Provision for early retirement, Provision for lump-sum distributions
- Explanation: Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal.
5. Workforce characteristics
- Variable: Age of workforce, active lives relative to retired lives
- Explanation: The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance.
General characteristics of DC plan
DC plans encompass arrangements that are
- pension plans, in which the contribution is promised and not the benefit
- profit-sharing plans, in which contributions are based, at least in part, on the plan sponsor’s profits.
The common elements of all these plans are:
- a contribution is made into an account for each individual participant,
- those funds are invested over time,
- the plans are tax-deferred
- upon withdrawal from the plan or reaching retirement, the participants receive the value of the account in either a lump sum or a series of payments.
The principal investment issues for DC plans
The principal investment issues for DC plans are as follows:
- Diversification. The sponsor must offer a menu of investment options that allows participants to construct suitable portfolios.
- Company Stock. Holdings of sponsor-company stock should be limited to allow participants’ wealth to be adequately diversified.
Participants in DC plans bear the risk of investment results. As a consequence, an investment policy statement for a DC plan fulfills a much different role than an investment policy statement for a DB plan.
Risk Objectives of Foundations
- Because foundations’ goals differ somewhat from those of traditional defined-benefit pension funds and other asset pools, foundations can have a higher risk tolerance.
- Foundations have no defined liability. The desire to keep spending whole in real terms, or to grow the institution, is simply that: a desire.
- Foundation investment policy can thus be more fluid or creative, and arguably more aggressive, than pension fund policy.
General composition of bank`s assets and liabilities
- Banks’ liabilities consist chiefly of time and demand deposits (as much as 90 percent of total liabilities and capital for smaller banks) but also include purchased funds and sometimes publicly traded debt.
- The asset side of the balance sheet consists of loan and securities portfolios as well as an assortment of other assets
Other Institutional Investors: Investment Intermediaries
- Investment companies include such investment vehicles as mutual funds (open-end investment companies), closed-end funds (closed-end investment companies), unit trusts, and exchange-traded funds.
- One cannot generally characterize the investment objects and constraints of a given type of investment intermediary with the expectation that it will apply to all members of the group.
- Nonfinancial corporations (i.e., businesses), although not financial intermediaries, are major investors in money markets (markets for fixed-income securities with maturities of one year or less) to manage their cash positions.
Examples of differences in liabilities, risk factors, and tax considerations for non-life companies vs. life companies
Liabilities, risk factors, and tax considerations for non-life companies are distinctly different from those for life companies.
For example:
- non-life liability durations tend to be shorter, and claim processing and payments periods are longer, than for life companies;
- some (but not all) non-life liabilities are exposed to inflation risk, although liabilities are not directly exposed to interest rate risk as those of life insurance companies; and
- in general, a life insurance company’s liabilities are relatively certain in value but uncertain in timing, while a non-life insurance company’s liabilities are relatively uncertain in both value and timing, with the result that non-life insurance companies are exposed to more volatility in their operating results.
Foundations and Endowments
Foundations are typically grant-making institutions funded by gifts and investment assets.
Endowments, on the other hand, are long-term funds generally owned by operating non-profit institutions such as universities and colleges, museums, hospitals, and other organizations involved in charitable activities.
Types of foundations
Four types of foundations exist:
1. Independent (also called private or family)
- Description: Independent grant-making organization established to aid social, educational, charitable, or religious activities.
- Source of Funds: Generally an individual, family, or group of individuals.
- Decision-Making Authority: Donor, members of donor’s family, or independent trustees.
- Annual Spending Requirement: At least 5% of 12-month average asset value, plus expenses associated with generating investment return.
2. Company sponsored
- Description: A legally independent grant-making organization with close ties to the corporation providing funds.
- Source of Funds: Endowment and/or annual contributions from a profit-making corporation
- Decision-Making Authority: Board of trustees, usually controlled by the sponsoring corporation’s executives.
- Annual Spending Requirement: Same as independent foundation.
3. Operating
- Description: Organization that uses its resources to conduct research or provide a direct service (e.g., operate a museum).
- Source of Funds: Largely the same as independent foundation..
- Decision-Making Authority: Independent board of directors.
- Annual Spending Requirement: Must use 85% of interest and dividend income for active conduct of the institution’s own programs. Some are also subject to annual spending requirement equal to 3.33% of assets.
4. Community
- Description: A publicly supported organization that makes grants for social, educational, charitable, or religious purposes. A type of public charity.
- Source of Funds: Multiple donors; the public.
- Decision-Making Authority: Board of directors.
- Annual Spending Requirement: No spending requirement.
From an investment standpoint, DC plans fall into two types
From an investment standpoint, DC plans fall into two types:
- Sponsor directed, whereby much like a DB plan, the sponsor organization chooses the investments. For example, some profit-sharing plans (retirement plans in which contributions are made solely by the employer) are sponsor directed.
- Participant directed, whereby the sponsor provides a menu of diversified investment options and the participants determine their own personalized investment policy. Most DC plans are participant directed.
Profitability measures of banks
Among the profitability measures that the ALCO will monitor are the following:
- The net interest margin, already mentioned, equals net interest income (interest income minus interest expense) divided by average earning assets. Net interest margin is a summary measure of the net interest return earned on income-producing assets such as loans and bonds.
- The interest spread equals the average yield on earning assets minus the average percent cost of interest-bearing liabilities. The interest spread is a measure of the bank’s ability to invest in assets yielding more than the cost of its sources of funding.
Time Horizon for life insurers
- Life insurance companies have long been considered the classic long-term investor. Traditionally, portfolio return objectives have been evaluated within the context of holding periods as long as 20 to 40 years. Most life insurance companies have traditionally sought long-term maturities for bond and mortgage investments. In addition, life companies have found equity investments (real estate, common stocks, convertible securities, and venture capital) attractive because of their capital appreciation potential and inflation (purchasing power) risk protection.
- Asset/liability management practices have tended to shorten the overall investment time horizon of the typical life insurance company. Today, portfolio segments have differing time horizons, reflected in each segment’s investment policies.
Determination of Portfolio Policies for non-life insurers
- As in the case of life insurance companies, casualty companies’ limited investment risk tolerance is the dominant factor in determining their investment policy. Because of contractual liabilities and difficulty in forecasting the cash flow from insurance operations, casualty companies seek some degree of safety from the assets offsetting insurance reserves.
- The structure of a casualty company’s bond portfolio between taxable and tax-exempt securities depends on the company’s underwriting experience and current tax policy.
- A casualty company’s investment and business operating policies and strategies must be closely coordinated given the volatility of both the capital markets and the casualty insurance markets.
What happend to the time horizon of insurance companies due to evolution of investment policies in the past 15-20 years?
The time horizon for life insurance companies has gotten shorter as the duration of the insurance products they offer has decreased
Liquidity Requirements of banks
A bank’s liquidity position is a key management and regulatory concern. Liquidity requirements are determined by net outflows of deposits, if any, as well as demand for loans.
Risk measures of banks
Among the risk measures the ALCO will monitor are the following:
- The leverage-adjusted duration gap is defined as DA – kDL, where DA is the duration of assets, DL is the duration of liabilities, and k = L/A, the ratio of the market value of liabilities (L) to the market value of assets (A). The leverage-adjusted duration gap measures a bank’s overall interest rate exposure. For a positive interest rate shock (unexpected increase in rates), the market value of net worth will decrease for a bank with a positive gap; be unaffected for a bank with a zero gap (an immunized balance sheet); and increase for a bank with a negative gap.32
- Position and aggregate Value at Risk (VAR) are money measures of the minimum value of losses expected over a specified time period (for example, a day, a quarter, or a year) at a given level of probability (often 0.05 or 0.01). As a result of risk-based capital regulatory initiatives internationally, nearly all banks track this measure of exposure to large losses.
- Credit measures of risk may include both internally developed and commercially available measures such as CreditMetrics.
Unique Circumstances for foundations
A special challenge faces foundations that are endowed with the stock of one particular company and that are then restricted by the donor from diversifying. The asset value of such an institution is obviously subject to the large market fluctuations attendant to any one-stock position.
Main features of underwriting cycles for P&C (property and casualty) insurance companies?
Evidence indicates that the P&C underwriting cycle lasts three to five years and tends to follow general business cycles.
- At the beginning of the cycle, the underwriting business is soft due to increased competition and excess insurance capacity, as a result of which premiums are low. Subsequently, a natural disaster or other catastrophe that leads to a surge in insurance claims drives lesser-capitalized insurers out of business.
- Decreased competition and lower insurance capacity lead to better underwriting conditions for the surviving insurers, enabling them to raise premiums and post solid earnings growth. This robust underwriting environment attracts more competitors, which gradually leads to more capacity and lower premiums, setting the stage for a repetition of the underwriting cycle.
Asset/liability management
Asset/liability management is a subset of a company’s overall risk management practice that typically focuses on financial risks created by the interaction of assets and liabilities; for given financial liabilities, asset/liability management involves managing the investment of assets to control relative asset/liability values
Non-Life Insurance Companies: Background and Investment Setting
- The liabilities, risk factors, and tax considerations for non-life companies are distinctly different from those for life companies.
- Tax planning has dominated the investment policy of non-life companies for decades, reflecting the cyclical characteristics of this segment of the insurance industry.
- A unique aspect of the casualty insurance industry is what is often described as the “long tail” that characterizes the industry’s claims reporting, processing, and payment structure.
- Whereas life insurance is heavily oriented toward products sold to or for individuals, commercial customers account for a very large portion of the total casualty insurance market.
- From an asset/liability management perspective, most casualty insurance companies traditionally have been classified as having relatively short-term liabilities, even though the spectrum of casualty insurance policies covers a wide range of liability durations.
- One of the primary factors that limits the duration of a non-life company’s assets is the so-called underwriting (profitability) cycle, generally averaging three to five years. These cycles typically result from adverse claims experience and/or periods of extremely competitive pricing.
- Estimating the duration of a casualty insurance company’s liabilities introduces a different set of issues than with life insurance liabilities. Using multiscenario and multifactor models, casualty actuaries attempt to capture
- the underwriting cycle
- the liability durations by product line
- any unique cash outflow characteristics.
Risk Objectives for endowments
- An endowment’s investment risk should be considered in conjunction with its spending policy and in the context of its long-term objective of providing a significant, stable, and sustainable stream of spending distributions.
- Endowments that do not use a smoothing rule may have less tolerance for short-term portfolio risk. Investment portfolios with very low volatility, or investment risk, usually provide low expected returns, which increases the risk of failing to achieve the endowment’s goals of significant, stable, and sustainable spending.
- An institution’s risk tolerance depends on the endowment’s role in the operating budget and the institution’s ability to adapt to drops in spending.
- On a short-term basis, an endowment’s risk tolerance can be greater if the endowment has experienced strong recent returns and the smoothed spending rate is below the long-term average or target rate.
- Despite their long-term investment mandate, endowment managers often come under pressure to perform well over relatively short-term time horizons.
Enchanced margin return, surplus return, minimum return for insurance companies
Enchanced margin: the rate associated with efforts to earn competitive returns on assets funding well-defined liabilities. Spread management techniques are used. If done succesfully, a return in excess of a policy’s crediting rate can be earned, giving life insurance companies a competitive edge in setting policy premiums and adding new business.
Surplus return: the difference between total assets and total liabilities is surplus. The primary objective of surplus management is to generate growth, which is key to expanding insurance volume.
Minimum return: the mandated return applied to assets market to meed death benefits. The minimum rate of return is a statutory rate (normally actuarially determined) that will ensure funding so that reserves are sufficient to meet mortality predictions.
Liquidity Requirement of DB plan
The net cash outflow (benefit payments minus pension contributions) constitutes the pension’s plan liquidity requirement.
The following issues affect DB plans’ liquidity requirement:
- The greater the number of retired lives, the greater the liquidity requirement, all else equal. As one example, a company operating in a declining industry may have a growing retired-lives portion placing increasing liquidity requirements on the plan.
- The smaller the corporate contributions in relation to benefit disbursements, the greater the liquidity requirement. The need to make contributions depends on the funded status of the plan. For plan sponsors that need to make regular contributions, young, growing workforces generally mean smaller liquidity requirements than older, declining workforces.
- Plan features such as the option to take early retirement and/or the option of retirees to take lump-sum payments create potentially higher liquidity needs.
Risk objectives of DB
- DB plans may state a risk objective relative to the level of pension surplus volatility (i.e., standard deviation).
- Another kind of ALM risk objective relates to shortfall risk with respect to plan liabilities. Shortfall risk may relate to achieving:
- a funded status of 100 percent (or some other level) with respect to the ABO, PBO, or total future liability;
- a funded status above some level that will avoid reporting a pension liability on the balance sheet under accounting rules; and
- a funded status above some regulatory threshold level.
- Other goals that may influence risk objectives include two that address future pension contributions:
- Minimize the year-to-year volatility of future contribution payments.
- Minimize the probability of making future contributions, if the sponsor is currently not making any contributions because the plan is overfunded.
- In addition to risk objectives relative to liabilities and contributions, sponsors may state absolute risk objectives, as with any other type of investing.
Cash flow characteristics in setting risk objectives for non-life insurers
Cash flow characteristics. Not surprisingly, cash flows from casualty insurance operations can be quite erratic. Unlike life insurance companies, which historically have been able to project cash flows and make forward commitments, casualty companies must be prepared to meet operating cash gaps with investment income or maturing securities. Therefore, for the portion of the investment portfolio relating to policyholder reserves, casualty companies have low tolerance for loss of principal or diminishing investment income. Investment maturities and investment income must be predictable in order to directly offset the unpredictability of operating trends.
