Lecture 1 Insurance Investments - uni-muenchen.de · Insurance companies and investments: Different view to assess the investment strategy . 1 (ii) Investments – The Legal View

Assets Liability Management for Insurance Companies

Lecture 1 Insurance Investments

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2 Insurance Investments

# Topic What is it about

1 (i) Insurance Investment Spectrum Insurance companies and investments: Different view to assess the investment strategy

1 (ii) Investments – The Legal View

Classification insurance investments following traditional supervisory rules: The focus is on the legal relation between the investor and its counterparty.

1 (iii) Measuring Investments – The Accounting View

Balance sheets are all about measuring the economic situation of an entity. However, different rules apply to measure the value of investments .

1 (iv) Assessing Investments – The Risk View

Knowing the economic “correct” value of an investment today, what is its value tomorrow. How to assess best and worst cases ? Which classification of investment reflecting their risk

Specific Literature Source Relevant Sections Comment

Albrecht, Maurer § 1.4.1 – 1.4.4 Qualitative description of investments for insurers. Description somehow complementary to the content of this lecture

AnlV: Anlageverordnung - Verordnung über die Anlage des gebundenen Vermögens von Versicherungsunternehmen

Source: http://www.bafin.de/DE/Unternehmen/VersichererPensionsfonds/Kapitalanlagen/kapitalanlagen__node.html?__nnn=true

List of admissible investment instruments for insurers (German supervisory regulation)

W.Rockel, E.Helten, H.Loy, P.Ott: Versicherungsbilanzen, Schäfer-Poeschel, 2005

Relevant: Chapter 4


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(i) Insurance Investment Spectrum Insurance companies and investments: Different view to assess the investment strategy

(ii) Investments – The Legal View

Classification insurance investments following traditional supervisory rules: The focus is on the legal relation between the issuer and the investor.

(iii) Measuring Investments – The Accounting View


(iv) Assessing Investments – The Risk View


Insurance Investments

Insurance Investment – Insurance Specifics Insurance Investment is different to other industries: They need to match future payouts to policyholders Considerable uncertainty in payout requirements (different to banks) Different needs within the insurance industry


Nonlife Insurance Life Insurance

“Short tail” “Long Tail” Risk Products Saving Products

Single or monthly premiums. Claims settlements at most 2 years after premium.

Single or monthly premiums. Claims settlement many years after premium.

Periodic premiums over many years. Claims (if at all) shortly after last premium.

Single or periodic premiums over many years. Normal payments at a fixed maturity date or annuity

E.g. fire and storm (private), automobile

E.g. industry, liability E.g. Mortality, accident, disability

E.g. Endowment (saving insurance), annuities

Manage cash to avoid liquidity shortcuts and optimise return

Manage investments to meet (uncertain) requirements with long time horizon

Similar to long-tail nonlife

Optimize investments (return shared with policyholders!) to be competitive and control risk

Insurance Investment – different views


• Insurance supervision (traditional) • Financial instruments regulation Legal view

• Optimize financial market presentation • Dividends • Policyholder participation (saving products)

Accounting view

• Insurance supervision (modern) • Controlling • Key impact on company strategy

Risk view

Relevance of the different view has changed drastically over time Till 2000: Insurance investors were lawyers Today: Economists and mathematicians play a key role

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(i) Insurance Investment Spectrum Insurance entities and investments: Different view to assess the investment strategy




Balance sheets are all about measuring the economic situation of an entity. However, different rules apply to measure the value of investments



Legal View – Example: The German Investment Directive


Instruments (8 categories)

Specifics 16 Sub-classes

Loans and receivables Money provided to third party with payback of nominal and interest according to fixed rules

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Asset backed loans Loan is backed by another security: Mortgages (real estate), Pfandbrief (state guarantee), policy loans.

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Subordinated loans Loan with payback subordinate in case of default 1

Fixed income bonds Borrowing with payback of nominal and interest based on a standardized contract (either tradable or with counterparty)

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Equity shares Share in the capital of another company providing rights and obligations (dividends, decide about the management)

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Real estate Belonging of ground and buildings 1

Investment fund shares

Share in a special investments entity managed on behalf of the investor

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Cash Money held at banks not backed by any guarantee 1

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Accounting View – Legal vs German HGB


Instruments Accounting Treatment

Cash, loans, receivables Moderate least value principle (“gemildertes Niederstwertprinzip”): Account value = Nominal amount provided as loan • Correction by upfront payments (agio, disagio) • Writedown required if permanent loss expected, otherwise writedown permitted

Asset backed loans

Subordinated loans

Fixed income bonds

Strict least value principle (Inhaberschuldverschreibung.): Account value = Acquisition value subject to writedowns • Writedown required if market value below acquisition price, unless classified as long-term investments

Equity shares Normal case: Like Inhaberschuldverschreibung but stricter writedown rules

Participations: Above a certain overall share only acquisition value is relevant (except after a credit default event)

Real estate Acquisition costs with scheduled writedowns (e.g. 2% p.a.)

Investment fund shares As equity shares (normal case)

Accounting View – Hidden Reserves/Losses HGB (1) Use of the least value principle gives rises to substantial distortions

of HGB accounts when compared to market values

Fixed income hidden reserves/losses: o If the interest on an old instrument is higher than the interest you would

get for a similar interest on a new emission with same maturity and credit quality, the old instrument has a higher market value. This is not reflected in the accounts. => The company could realized risk-less gains

o If the interest is lower, the current value of the instrument is below the accounting value (nominal). => Under liquidation a loss is realized

o Changes in the credit quality of the counterparty give rise to hidden reserves (under improvements) or hidden losses (if credit risk rises). The former will not be shown in any case, the latter need not be shown depending on the classification (permanent or temporary expectation of losses)


Accounting View – Hidden Reserves/Losses HGB (2) Other investments hidden reserves/losses:

Equities and investment fund shares o Typically there are hidden reserves: If market values drop below the price

at acquisition the loss needs to be realized

o Realized losses are locked in

o If market values risk above value at acquisition or latest writedown this is not reflected in the account.

o Critical: Writedown can be avoided when losses are expected to be “temporary” and investment is classified as “long-term”. (Abuse of misjudgement can drive a company to default).

Participations and real estate: o Typical no liquid market values exist.

o Long term holdings may have undergone high unrealized value changes.

o Scheduled writedowns on real estate distort real value signficantly.

o Writedowns on participations only in extreme cases (credit events) 12 Insurance Investments

Accounting View – Different accounting philosophies: HGB vs IFRS HGB focus: Bondholder protection through prudent valuation

approach. For Life insurers a prudence serves policyholder protection. Accounting and supervisory system completely aligned.

IFRS focus: Shareholder information through use of market values wherever possible. Supervisory system distinct from accounting.

HGB recent developments: o Balanced system between accounting and policyholder protection broken

up by recent decisions in respect of customer protection. (Imprudent policyholder participation, asymmetric treatment of hidden reserves and hidden losses).

o BilMoG (I and II): Some steps to introduce more market values in accounting (e.g. treatment of derivatives)

o Solvency II: Link between accounting and supervision broken up. 13 Insurance Investments

Accounting View – Classification IFRS (til 2013) IFRS: Intention for holding a financial instrument determines

accounting (instead of legal classification under HGB)

Participations: subject to similar rules as under HGB Real estate: Cost basis with regular revaluation


4 Categories Specifics

Loans and receivables Amortized Cost Accounting: Valuation based on price at acquisition modified by time effects (agio, disagio). Writedown whenever there is an sustainable expectation loss under long-term perspective.

Held to Maturity

Available for Sale Fair Value through OTC: Valuation at market value for the balance sheet. “Normal” market movements will not booked as gain/loss but just as a change in equity. (Non distributable earnings.) Writedown through P/L whenever change of values appears to be sustainable. No writeup through P/L.

Held for Trading Fair Value through P/L: Valuation at market value for the balance sheet. All changes will be booked in P/L (distributable earnings).

Accounting View – Classification IFRS (forthcoming) IFRS accounting shown downsides in the financial crises (for

banks but rarely for insurers).

=> Forthcoming IFRS 9 (Investment instruments)


3 Categories Condition

Amortized Costs Class Allowed and required, if Instrument pays only nominal and interest (no derivative component) Business model based on a “buy-and-hold” strategy for this instrument.

Fair Value Option Class In order to avoid accounting mismatch amortized cost instruments be designated as “fair value through P/L”

Fair Value (Residual Class)

All instruments that don’t apply for the amortized cost class, in particular equity instruments and instruments with embedded derivative.

Fair Value OCI Option Equity instruments can be designated to the OCI class (value changes not shown in P/L). Relevant for participations.

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Risk View – Basic Question Goal: Measure values on an “economical sustainable” basis Estimate how sustained the investment can be tomorrow under different

scenarios (best estimate, moderate pessimistic, worst case) Different approaches: Traditional: Prudent valuation today with explicit supervisory investment

constraints o Assume that losses need to be realized (slowly) over time o Investor need to deprecate losses immediately

Risk based measure: Measure current value and apply worst case capital market stress (typically one-year horizon) o Company’s capital position should be sufficient to survive one-year extreme

stress without counter measurers

Multi-year simulation: Assume bad market movements (mid term focus) and consider assets and liabilities o Company’ should survive long-term adverse development, allowing for

appropriate countermeasures (management strategies)


Risk View – Prudent Measurement Approach Measure investment instruments with a certain degree of prudence

(“risk margin”) above the traded market value

o Note: Market values per se already contain some prudence since buyers typically are risk adverse and require some risk margin anyhow. But this is not sufficient.

HGB has a prudent measurement, but is not economically sound nor explicate. Looking back (least value principle) tells nothing about the future and the approach is not instruments specific.

Supervisory prudence ensured by quantitative constraints in the use of any asset class (e.g. maximum of 30% equities)

A reasonable “prudent measurement approach” would a “what-if” assessment of the value of specific instruments under adverse scenario. It has to be ensured financial assets measured this way exceed the companies liabilities.


Risk View – Solvency II Approach


Measure investment instruments without any prudence above the traded market value

It assure prudent assessment of risk the value of financial instruments need to be shocked. Solvency II based on a pre-defined stress test reflecting a worst case scenario (1 in 200 years event) for interest rates, equity and real estate prices, credit risk.

Solvency Capital Requirement (SCR) defined as difference of current value of investments and value of investments under the shock with a one-year time perspective.

In order to ensure that an insurer is solvent its own funds need to excess the SCR.

Solvency II Approach – Critical Assessment One year shock scenarios may not be appropriate when assessing

where policyholder obligations are long-terms. This is a special problem for long-term fixed income investments where there is no intention for trading them.

Drives a procyclic investment policy (the same problem as under current IFRS).

Strategic participations (held under with a long time horinzon are treated like traded equity)

Universal calibration of the relevant shock events is to some extend artificial and reflects politics (e.g. universal real estate shocks irrespective very different markets; no shocks on EU government bonds).

Economic view spoiled by industry lobbying (long-term interest rates, manipulations at the equity shock in times of crises, ...)


Risk View – Multiyear Assessment


For Life insurers, additional to the Solvency II measurement, a term consideration is required in order to steer investments appropriately. o Avoid unnecessary procyclical behaviour in the investment strategy

o Take into account long-term factors into the risk assessment

o Take into account double hits and impact of volatility

The way to go: o Establish an appropriate (and robust) capital market model

o Calibrate to model prudently, e.g. based on the SCR one year shocks

o Run the model on a long-term perspective with stochastic scenarios

o Investigate the probability of critical scenarios and check how countermeasures in a later stage allow to keep the risk in adverse scenarios under control.

The best model only helps if the investment policy is disciplined !

Lecture 1 Insurance Investments - uni-muenchen.de · Insurance companies and investments: Different view to assess the investment strategy . 1 (ii) Investments – The Legal View

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