Reading 13 Managing Institutional Investor Portfolios Flashcards

Question

Foundations and Endowments

Answer 1

**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.

Answer 2

*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.

Answer 3

1. The most noteworthy aspect of foundations is that they *can vary widely* in their investment goals and time horizons 2. Often, a foundation’s mission may address a problem with a *limited time horizon or an urgent need*. 3. Another distinctive characteristic of the foundation sector, as contrasted to endowments, is that most private and family foundations *must generate their entire grant-making and operating budget from their investment portfolio* for the following reasons: these institutions generally do not engage in fund-raising campaigns; they may not receive any new contributions from the donor; and they do not receive any public support.

Answer 4

* 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.

Answer 5

* Some foundations are meant to be short lived; others are intended to operate in perpetuity. For those foundations with an indefinitely long horizon, the long-term return objective is to *preserve the real (inflation-adjusted) value of the investment assets* while allowing spending at an appropriate (either statutory or decided-upon) rate. * If we look at the 5 percent annual spending minimum for foundations as a benchmark and add 0.3 percent as a low-end estimate of investment management expenses (i.e., the cost of generating investment returns), we thus have calculated that the fund must generate a return of 5.3 percent, plus the inflation rate, to stay even in real terms. *We can use 5.3 percent plus the expected inflation rate as a starting point for setting the return objective of a foundation*.

Answer 6

* A foundation’s liquidity requirements are *anticipated or unanticipated needs for cash in excess of contributions* made to the foundation. Anticipated needs are captured in the periodic distributions prescribed by a foundation’s spending rate. * To avoid large fluctuations in their operating budget, foundations may use a smoothing rule. A **smoothing rule** averages asset values over a period of time in order to dampen the spending rate’s response to asset value fluctuation. * *Carry-forwards* and *carry-backs* not only make smoothing rules workable but also allow a foundation to make a large grant in a single year without compromising the long-run soundness of its investment program. * It is prudent for any organization to keep some assets in cash as a *reserve for contingencies*, but private and family foundations need a cash reserve for a special reason: They are subject to the unusual requirement that spending in a given fiscal year be 5 percent or more of the 12-month average of asset values _in that year_. One cannot, of course, know what this amount will be in advance, so one cannot budget for it. Instead, a well-managed foundation places some (say 10 percent or 20 percent) of its annual grant-making and spending budget in a reserve.

Answer 7

* The majority of foundation wealth resides in private and other foundations established or managed with the intent of lasting into *perpetuity*. * Investors often assume that a longer time horizon implies a greater ability to bear risk because a longer horizon affords them more time to recoup losses.

Answer 8

* In the United States, income that is not substantially related to a foundation’s charitable purposes may be classified as **unrelated business income** and be subject to regular corporate tax rates. * In the United States, a _private_ foundation must estimate and pay quarterly in advance a tax (currently set at 2 percent) on its net investment income. So, it is not tax exempt. * *Private foundation* investment income is taxable, whereas *other foundations* and endowments are not.

Answer 9

Foundations may be subject to a variety of legal and regulatory constraints, which vary by country and sometimes by type of foundation.

Answer 10

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.

Answer 11

* Legally and formally, however, the term “endowment” refers to a permanent fund established by a donor with the condition that the fund principal be maintained over time. In contrast to private foundations, endowments *are not subject to a specific legally required spending level*. * Donors establish true endowments by making gifts with the stipulation that periodic spending distributions from the fund be used to pay for programs and that the *principal value of the gift be preserved in perpetuity.* * Many schools and nonprofit organizations will supplement true endowments with voluntary savings in the form of *quasi-endowments*, sometimes referred to as *funds functioning as endowment (FFE)*. Although designated as long-term financial capital, quasi-endowments have no spending restrictions; the institution may spend such funds completely. Because endowments are owned by nonprofit organizations, they generally are exempt from taxation on investment income derived from interest, dividends, capital gains, rents, and royalties.

Answer 12

*The geometric smoothing rule description reflects this approach and uses the prior year’s beginning, rather than ending, endowment market value.* * Today, most endowed institutions determine spending through policies based on *total return* as reflected in market values. * Spending is typically calculated as a percentage, usually between 4 percent and 6 percent of endowment market value (endowments are not subject to minimum spending rates as are private foundations in the United States). * In calculating spending, endowments frequently *use an average* of trailing market values rather than the current market value to provide greater stability in the amount of money distributed annually. * Examples of spending rules include the following: **Simple spending rule**. Spending equals the spending rate multiplied by the market value of the endowment at the beginning of the fiscal year. Spending_t = Spending rate × Ending market value_t–1 **Rolling three-year average spending rule.** Spending equals the spending rate multiplied by the average market value of the last three fiscal year-ends. Spending_t = Spending rate × (1/3)[Ending market value_t–1 + Ending market value_t–2 + Ending market value_t–3] **Geometric smoothing rule.** Spending equals the weighted average of the prior year’s spending adjusted for inflation and the product of the spending rate times the market value of the endowment at the beginning of the prior fiscal year. The smoothing rate is typically between 60 and 80 percent. Spending_t = Smoothing rate × [Spending_t–1 × (1 + Inflation_t–1)] + (1 – Smoothing rate) × (Spending rate × Beginning market value_t–1)

Answer 13

* 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.

Answer 14

* Endowment funds should *maintain* their long-term *purchasing power after inflation*. * *If returns had no volatility*, an endowment could set spending at a rate that equated to the real return — that is, the nominal return net of inflation. * Risk of short-term disruptive spending *may be reduced* with a smoothing rule. * Finally, a *low-volatility, low-return portfolio* increases the risk of an endowment failing to meet its objectives. In summary, an endowment must coordinate its investment and spending policies. An endowment’s returns need to exceed the spending rate to protect against a long-term loss of purchasing power. Calculating the return objective as the sum of the spending rate, the expected inflation rate, and the cost of generating investment returns can serve as a starting point for determining an endowment’s appropriate return objective (analogous to the approach previously discussed for foundations). As is clear from Monte Carlo analysis in a multi-period setting, however, an endowment may need to set its return objective higher than the above starting point in order to preserve its purchasing power. In addition, an endowed institution should adopt a spending policy that appropriately controls the risk of long-term purchasing power impairment and dampens short-term volatility in spending distributions. Unlike foundations, endowments are not subject to specific payout requirements. The endowment can set a long-term spending rate consistent with its investment approach. Furthermore, spending policies can include a smoothing rule, which gradually adjusts to changes in endowment market values, to dampen the effects of portfolio volatility on spending distributions.

Answer 15

The perpetual nature and measured spending of true endowments *limit their need for liquidity.*

Answer 16

In principle, endowment time horizons are extremely long term because of the objective of maintaining purchasing power in *perpetuity*.

Answer 17

Taxes are not a major consideration for endowments, in general.

Answer 18

Many large endowments have been leaders in adopting investments in alternative investments, such as private equities, real estate, natural resources, and absolute return strategies. These investments often require significant staff time and expertise to find, evaluate, select, and monitor. Because the **active management** component of returns in these alternative, less-efficient markets is extremely important to long-term success, endowments should have significant resources and expertise before investing in nontraditional asset classes.

Answer 19

* Insurance companies, whether life or casualty, are established either as **stock companies** (companies that have issued common equity shares) or as **mutuals** (companies with no stock that are owned by their policyholders). * Many of the major mutual insurance companies in the United States, Canada, the United Kingdom, and continental Europe have completed or are in the process of **demutualizing** (converting to stock companies).

Answer 20

* Exposure to interest-rate-related risk is one major characteristic of life insurers’ investment setting. Besides fixed-income portfolio gains and losses related to interest rate changes, many life insurance company liabilities such as annuity contracts are *interest rate sensitive*. In addition, insurers also face the risk of *disintermediation*, which often becomes acute when interest rates are high. * One type of disintermediation occurs when policyholders *borrow against the accumulated cash value* in insurance products such as ordinary life insurance. US life insurance companies experienced unprecedented disintermediation in the early 1980s. As interest rates reached record high levels (in the mid to high teens) during that period, policyholders took advantage of the option to borrow some or all of the accumulated cash value in their policies at the below-market policy loan rates (generally 5 to 9 percent) that were contractually defined in their insurance policies. * When interest rates are high, insurers also face another type of disintermediation: the risk that policyholders will surrender their cash value life insurance policies for their accumulated cash values, in order to reinvest the proceeds at a higher interest rate. As a result of these forces, insurers face marketplace pressures to offer competitive cash value accumulation rates or **credited rates** (rates of interest credited to a policyholder’s reserve account). * Universal life, variable life, and variable universal life represent the insurance industry’s response to disintermediation. Companies developed these products to offset the competitive appeal of buying term insurance and investing the difference between term insurance premiums and the often higher premiums of ordinary life insurance policies.

Answer 21

* An insurance company’s primary investment objective is to *fund future policyholder benefits and claims*. * To absorb some modest loss of principal, US life insurance companies are *required to maintain an asset valuation reserve*. * Insurance regulators worldwide have been moving toward *risk-based capital (RBC) requirements* to assure that companies maintain adequate surplus to cover their risk exposures relating to both assets and liabilities. * *Asset/liability risk considerations* figure prominently in life insurers’ risk objectives, not only because of the need to fund insurance benefits but also because of the importance of interest-rate-sensitive liabilities. Examples of such liabilities are annuities and deposit-type contracts, such as GICs and funding agreements (stable-value instruments similar to GICs).

Answer 22

* **Valuation concerns**. In a period of changing interest rates, a mismatch between the duration of an insurance company’s assets and that of its liabilities can lead to *erosion of surplus*. Life insurance companies are particularly sensitive to the losses that can result during periods of rising interest rates from holding assets with an average duration that exceeds the average duration of liabilities. (Adding to insurers’ concerns is the fact that the risk of disintermediation is greatest in such interest rate environments.) In these situations, the existence of valuation reserves alone may be insufficient to prevent a write-down of surplus, possibly creating a capital adequacy problem. Consequently, valuation concerns tend to limit insurers’ risk tolerance. * **Reinvestment risk**. For many life insurance companies, especially those competing for annuity business, yet another risk factor can be significant—reinvestment risk. *Reinvestment risk* is defined as the risk of reinvesting coupon income or principal at a rate less than the original coupon or purchase rate. For annuity contracts on which no interest is paid until maturity (the terminal date) of the contract, the guarantee rate typically includes the insurance company’s best estimate of the rate(s) at which interest payments will be reinvested. If a company does not carefully manage its asset and liability durations, an unexpected decline in interest rates can jeopardize the profitability of these contracts. Thus, controlling reinvestment risk is also an important risk objective. * **Credit risk**. Credit risk represents another potential source of income loss for insurance companies, although credit analysis has long been considered one of the industry’s strengths. Insurers seek to control this risk through broad diversification and seek adequate compensation for taking risk in terms of the expected return or interest rate spread when investing in various asset classes. Risk objectives may relate to losses caused by credit risk. * **Cash flow volatility.** Loss of income or delays in collecting and reinvesting cash flow from investments is another key aspect of risk for which life insurance companies have low tolerance. Compounding (interest on interest) is an integral part of the reserve funding formula and a source of surplus growth. Actuaries assume that investment income will be available for reinvestment at a rate at least equal to an assumed (minimum return) rate. Controlling cash flow volatility is thus a risk objective. Despite the above four risk-related considerations, competition has modified the traditional conservatism of life insurance companies, motivating them to accept and manage varying degrees of risk in pursuit of more competitive investment returns.

Answer 23

* The shortfall is reflected in a decrease in surplus or surplus reserves, assuming the simplest case. The insurer, in short, desires to earn a positive net interest spread, and return objectives may include a desired net interest spread. (The **net interest spread** is the difference between interest earned and interest credited to policyholders.) * In the United States, with whole-life insurance policies, the minimum statutory accumulation rate for most life insurance contracts ranges *between 3 and 5.5 percent.* * Consistently above-average investment returns should and do provide an insurance company with some *competitive advantage* in setting premiums. Life insurance companies have found that an improvement as small as 10 basis points (0.10 percent) in the total portfolio yield improves their competitive position and profitability significantly. * **Segmentation** of insurance company portfolios has promoted the establishment of sub-portfolio return objectives to promote competitive crediting rates for groups of contracts. The major life insurance companies find themselves specifying return requirements by major line of business, the result being that a single company’s investment policy may incorporate multiple return objectives. * Another dimension of return objectives for life insurance companies relates to the *need to grow surplus* to support expanding business volume.

Answer 24

* Traditionally, life insurance companies have been characterized as needing *minimal liquidity*. * However, *volatile interest rate environments* and the ever-increasing importance of annuity products require that life companies pay close attention to their liquidity requirements. * In assessing their liquidity needs, insurers must address *disintermediation and asset marketability risk*. * The growth and development of the *derivatives market* has broadened the life insurance industry’s ability to manage interest rate risk and reduced companies’ need to hold significant liquidity reserves. Many companies also maintain lines of credit with banks for added liquidity.

Answer 25

**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.

Answer 26

**Asset marketability risk.** The marketability of investments is important to insure ample liquidity. Life insurance companies have traditionally invested some portion of their portfolios in less liquid investments, such as private placement bonds, commercial mortgage loans, equity real estate, and venture capital. Increasingly, liquidity considerations are constraining the percentage invested in these asset classes.

Answer 27

* 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*.

Answer 28

* Unlike pension funds and endowments, insurance companies are *tax-paying* rather than wholly or partially tax-exempt investors. As commercial enterprises, they are subject to income, capital gains, and other types of taxes in the countries where they operate. The types and application of taxes differ by country, but in all cases, taxes mean that insurance companies must focus on after-tax returns in their investment activities. * In a very simplified context, life insurance companies’ investment income can be divided into two parts for tax purposes: *the policyholders’ share (that portion relating to the actuarially assumed rate necessary to fund reserves) and the corporate share (the balance that is transferred to surplus)*. Under present US law, only the latter portion is taxed. * One very important tax consideration being watched carefully by the US life insurance industry relates to the tax treatment of the so-called *inside buildup of cash values* under a life insurance policy or annuity. * Tax law changes that would reduce or eliminate the tax deferral granted to the inside buildup would create significant competitive issues for the life insurance industry.

Answer 29

* Insurance is a heavily regulated industry. * Important concepts related to regulatory and legal considerations include eligible i*nvestments, 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.

Answer 30

* The liabilities, risk factors, and tax considerations for non-life companies are d*istinctly 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.

Answer 31

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*.

Answer 32

* The *ability to meet policyholders’ claims* is a dominant consideration influencing investment policy * In setting risk objectives, casualty companies must consider both *cash flow characteristics* and the *common stock to surplus ratio*. * Unlike the life insurance industry, the casualty industry has almost *no absolute limits* imposed by regulation (in the United States, some states do limit commons stocks as a percentage of surplus). However, many casualty companies have adopted *self-imposed limitations* restricting common stocks at market value to some significant but limited portion (frequently one-half to three-quarters) of total surplus.

Answer 33

**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.

Answer 34

**Common stock** **to surplus ratio.** Inflation worldwide has further reduced investment risk tolerance among many casualty insurers. In fact, volatile stock market conditions in the 1970s persuaded many casualty companies to reduce the percentage of surplus invested in common stock.

Answer 35

* Casualty insurance companies were once thought to be operating as if they were *two separate organizations*—an insurance company and an investment company operating a balanced fund (a fund holding a mixture of bonds and stocks). However, times have changed and the investment and operating functions are much more closely coordinated now. Factors influencing return objectives include c*ompetitive pricing policy, profitability, growth of surplus, tax considerations, and total return management*. * One of the most interesting characteristics of casualty insurance companies is that their investment returns *vary significantly* from company to company. This variation reflects * 1) the latitude permitted by insurance regulations; * 2) differences in product mix, and thus in the duration of liabilities; * 3) a particular company’s tax position; * 4) the emphasis placed on capital appreciation versus the income component of investment return; and * 5) the strength of the company’s capital and surplus positions.

Answer 36

* **Competitive policy pricing**. Low insurance policy premium rates, due to competition, provide an incentive for insurance companies to set high desired investment return objectives. The flip side is that high investment returns may induce insurance companies to lower their policy rates, even though a high level of returns cannot be sustained. * Thus any influence of competitive policy pricing on a casualty company’s return objectives needs to be assessed in light of well-thought-out capital market assumptions and the insurance company’s ability to accept risk.

Answer 37

* **Profitability**. Investment income and the investment portfolio return are primary determinants of continuing profitability for the typical casualty company and, indeed, the industry. The underwriting cycle influences the volatility of both company and industry earnings. * Given the underwriting uncertainties inherent in the casualty insurance business, investment income obviously provides financial stability for the insurance reserves. In fact, investment earnings are expected to offset periodic underwriting losses (claims and expenses in excess of premium income) from the insurance side of the company.

Answer 38

* **Growth of surplus.** An important function of a casualty company’s investment operation is to provide growth of surplus, which in turn provides the opportunity to expand the volume of insurance the company can write. * The risk-taking capacity of a casualty insurance company is measured to a large extent by its *ratio of premiums to capital and surplus*. Generally, companies maintain this ratio *between 2-to-1 and 3-to-1*, although many well capitalized companies have lower ratios.

Answer 39

* **Tax considerations.** Over the years, non-life insurance companies’ investment results have been very sensitive to the after-tax return on the bond portfolio and to the tax benefits, when they exist, of certain kinds of investment returns. * *Recent changes in the tax laws* have diminished most of the tax benefits available to casualty insurance companies. Outside of the United States, tax-exempt securities for insurance companies either do not exist or are more limited in supply. For non-US insurance companies, therefore, taxes are *even more of a constraint*.

Answer 40

**Total return management.** Active bond portfolio management strategies designed to achieve total return, rather than yield or investment income goals only, have gained popularity among casualty insurance companies, especially large ones. Because GAAP and statutory reporting require that realized capital gains and losses flow through the income statement, the decline in interest rates and increase in bond prices since 1982 have encouraged casualty insurance portfolio managers to trade actively for total return in at least some portion of their bond portfolios.

Answer 41

* Given the uncertainty of the cash flow from casualty insurance operations, liquidity has always been a *paramount consideration* for non-life companies, in sharp contrast with life insurance companies which face relatively certain cash flows, excluding policy loans and surrenders. In addition to its use in meeting cash flow needs, liquidity has also been a *necessary adjunct of a casualty company’s variable tax position*. * To meet its liquidity needs, the typical casualty company does *several things* related to the marketability and maturity schedule of its investments. Quite often it maintains a portfolio of short-term securities, such as commercial paper or Treasury bills, as an immediate liquidity reserve. * Needless to say, such attention to maturity and marketability complements the *limited risk tolerance* and further modifies the return objectives of casualty insurers.

Answer 42

* The time horizon of casualty insurance companies is a function of *two primary factors*. First, the durations of casualty liabilities are typically *shorter* than those of life insurance liabilities. Second, underwriting cycles affect the mix of taxable and tax-exempt bond holdings. Because the tax-exempt **yield curve** in the United States tends to be more positively sloped than the taxable curve, casualty companies find that they must invest in longer maturities (15 to 30 years) than the typical life company to optimize the yield advantage offered by tax-exempt securities * Differences in the average maturity of bond portfolios between casualty and life insurance companies may also reflect the companies’ *willingness* to accept interest rate risk via asset/liability duration mismatches and trade at least some portion of their portfolios through a market or underwriting cycle.

Answer 43

* Tax considerations are a *very important factor* in determining casualty insurance companies’ investment policy. Prior to changes in the tax law in 1986, US casualty insurance companies operated under a relatively simple and straightforward set of tax provisions. As a result of the 1986 changes, tax-exempt bond income became subject to tax for US casualty insurance companies. * As in the life insurance industry, casualty insurers are likely to be subjected to further *tax code modification,* which increases uncertainty for the investment manager as to the tax consequences of certain portfolio activities or alternatives when measured over a long time horizon.

Answer 44

* 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.

Answer 45

* As in the case of life insurance companies, casualty companies’ l*imited 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.

Answer 46

* 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

Answer 47

Traditionally, a bank’s portfolio of investment securities has been a *residual use of funds* after loan demand has been met. The securities portfolio nevertheless plays a key role in managing a bank’s risk and liquidity positions relative to its liabilities. Consequently, a bank’s *asset/liability risk management committee (ALCO)* is generally in charge of overseeing the bank’s securities portfolio. Among the *profitability measures* that the ALCO will monitor are the following: * net interest margin * interest spread Because both interest income and interest expense fluctuate in response to interest rate changes, net interest margin and interest spread are key indicators of a bank’s ability to profitably manage interest rate risk. Among the *risk measures* the ALCO will monitor are the following: * Leverage-adjusted duration gap * Value at Risk (VAR) * Credit measures of risk may include both internally developed and commercially available measures such as CreditMetrics. Banks’ *objectives* in managing securities portfolios include the following, listed in order of importance: * To manage overall interest rate risk of the balance sheet. * To manage liquidity. * To produce income. * To manage credit risk. Banks also use their securities portfolios to meet other needs. For example, in the United States, banks must hold (pledge) government securities against the uninsured portion of deposits (an example of a **pledging requirement**—i.e., a required collateral use of assets). Just as a bank’s liabilities are interest-rate sensitive (as is its loan portfolio, on the asset side), a bank’s security portfolios consist almost exclusively of fixed-income securities. This characteristic, as well as the bias toward low-credit risk holdings, is reinforced by regulatory constraints on securities holdings.

Answer 48

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.

Answer 49

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.

Answer 50

Banks’ objectives in managing securities portfolios include the following, listed in order of importance: * **To manage overall interest rate risk of the balance sheet.** In contrast to business, consumer, and mortgage loans, bank-held securities are negotiable instruments trading in generally liquid markets that can be bought and sold quickly. Therefore, securities are the natural adjustment mechanism for interest rate risk. For example, if the duration of equity is higher than desired, a bank can shorten it by shortening the maturity of its securities portfolio. * **To manage liquidity.** Banks use their securities portfolios to assure adequate cash is available to them. The rationale for selling securities to meet liquidity needs is again the ready marketability of securities. * **To produce income.** Banks’ securities portfolios frequently account for a quarter or more of total revenue. * **To manage credit risk.** The securities portfolio is used to modify and diversify the overall credit risk exposure to a desired level. Banks frequently assume substantial credit risk in their loan portfolios; they can balance that risk by assuming minimal credit risk in their securities portfolio. Additionally, they can use the securities portfolio to diversify risk when the loan portfolio is not adequately diversified.

Answer 51

* As already emphasized, banks’ risk objectives are dominated by ALM considerations that focus on *funding liabilities*. Therefore, risk relative to liabilities, rather than absolute risk, is of primary concern. * Overall, banks have *below-average risk tolerance* as concerns the securities portfolio.

Answer 52

A bank’s return objectives for its securities portfolio are *driven by the need to earn a positive return on invested capital*.

Answer 53

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.

Answer 54

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).

Answer 55

Banks’ securities portfolios are *fully taxable*.

Answer 56

* 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.

Answer 57

There are *no common unique circumstance*s to highlight relative to banks’ securities investment activities.

Answer 58

* 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.

Answer 59

**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.

Answer 60

* Cash flow volatility, * reinvestment risk, * credit risk, and * asset valuation fluctuations are generally considered to be the most important risk factors to be evaluated when determining the *risk objectives* of a life insurance companies. *Liquidity* is directly affected by the possibility of: * disintermediation, * asset-liability mismatches, * and marketability risk.

Answer 61

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.

Answer 62

* The **ladder strategy** approach staggers investments with *equal amounts* invested throughout the maturity spectrum. Over time, periodic reinvestment is required. * With a **barbell aproach**, investments are made both on the short and the long ends of the maturity spectrum; *weighted more heavily on one end or the other* depending upon the manager's interest rate outlook. * A **bullet** strategy concentrates the maturities of the bonds in the portfolio around *a single point* on the yield curve.

Answer 63

The time horizon for life insurance companies has gotten shorter as the duration of the insurance products they offer has decreased

Answer 64

Advantages to the sponsor: * In the DC setting, the Sponsor does not have responsibility to set objectives and constraints; rather, the plan participants set their own risk and return objectives and constraints * The Sponsor does not bear the risk of investment results; employees and beneficiaries bear the risk * The Sponsor's future pension obligations are more stable and predictable * The Sponsor does not need to recognize any additional pension liabilities on its balance sheet under the new plan * As long as the Sponsor provides a wide range of investment choices and periodically evaluates them, it fulfils its fiduciary responsibilities as the plan sponsor Advantages to employees: * The participant is able to choose a risk and return objective reflecting his or her own personal financial circumstances, goals, and attitudes toward risk * DC plan assets are more readily portable * DC plans do not present early termination risk, i.e., the risk that the plan is terminated by the sponsor * Participants can rebalance and re-allocate investments * Account balances legally belong to participants

Reading 13 Managing Institutional Investor Portfolios Flashcards

(88 cards)