Managing Institutional Investors: Short Term Insurers

Explain the risk objectives

Risk objectives are the factors that help define the risk appetite of an investor and is associated
with the ability and the willingness of the investor to take up risks (Borad, 2018). It is therefore
termed as the risk tolerance when both the ability to accept certain types of risks and willingness
are combined. The risk objectives focus mainly on the specific measures of risk and the
investor’s ability and willingness to take the risks.

According to Richeinstein (2013) just like life insurance companies, short-term insurance firms
have a quasi-fiduciary role which is why the ability to meet policyholders’ claims or liabilities
is as a significant factor that influences investment policy (Banks, 2016).

When it comes to the predictability of the risks insured by casualty companies, they are
generally less predictable (Richeinstein, 2013). However the loss potential can be considerably
high for those insurers that are exposed to catastrophic events such as tornadoes, explosions
and hurricanes.

The effects of inflation also adds to the degree of risk. This is the case since, non-life policies
frequently provide replacement cost or current cost coverage. Taking for example the current
situation in Zimbabwe since the introduction of the SI142 that saw the bun of the multi-
currency regime and the sudden hikes and spikes in the local currencies exchange rates to an
extent that spikes the replacement costs for short-term companies (IPEC, 2019).

In setting risk objectives, casualty companies must consider both cash-flow characteristics and
the common stock-to-surplus ratio (Meier, 2017). This is because their cash flows are erratic
in nature and generally requires these short-term insurers to consider settling shortfalls with
investment income. When it comes to stock to surplus ratio considerations this is to do with
the fact that stock market conditions that are highly volatile can reduce the common stock to
surplus ratio for the short-term companies and this due to the possibilities of quick liquidation
of the stocks (Richeinstein, 2013).
Return objectives

Return objectives can be stated in two ways, which are relative and absolute basis (Forjan,
2018). Desired returns that are stated in real or nominal terms are regarded as absolute return
objectives whilst relative return objectives can be performance relative to a peer group or a
specific index (Chen, 2020). For example a return objective can be stated as a portfolio target
of annual returns within 3% of the MSCI World Index or returns of plus or minus 5% of the
NASDAQ annual return. On that note, a number of steps are required to determine the return
objectives for an investor and this include but not limited to specifying the measure of return,
determining the desired return, required return and setting specific return objectives (Forjan,
2018).

According to Richeinstein (2013), most short-term insurance companies have not completely
taken into account investment earnings during premium calculations over the years. For this
reason, short-term insurance companies were regarded as two separate organizations operating
simultaneously as an insurance firm and an investment firm that operates a balanced fund. Over
time the operations and investment functions were coordinated and they are a number of factors
that influences the return objectives and these include competitive pricing policy, profitability,
and growth of surplus, tax considerations, and total return management.

Competitive policy pricing

The incentive to set high investment return objectives is as a result of high competition levels,
low insurance policy premium rates (Ang and Lai, 1987). It is through the high investment
returns that the short-term company may be encouraged to lower their policy rates, even though
a high level of returns may not be sustained. Any influence of competitive policy pricing on a
short-term company’s return objectives has to be fully assessed through technical and
fundamental analysis so as to make well thought out capital market assumptions and also taking
into account the insurance firm’s ability to accept risk.

Profitability

Investment income and the investment portfolio returns are the primary determinants of
continued profitability for a typical short-term insurance company as well as the industry at
large (Meier, 2017).The various changes in the company and industry earnings are greatly
influenced by the volatilities caused by the underwriting cycles. The return requirements for
short-term insurance companies are not framed in reference to a crediting rate for their policies
but instead the portfolios are managed so as to maximize the return on capital and surplus to
such an extent that prudent asset or liability management, surplus adequacy considerations, and
management preferences can allow (Richeinstein, 2013).

Investment income helps improve overall profitability, thus, obviously providing financial
stability for the insurance reserves and guides against the adverse effects of the underwriting
uncertainties inherent in the short-term insurance business (Ashraf, 2016). For most insurers
investment earnings helps to offset periodic underwriting losses resulting from claims and
expenses that will be in excess of premium income generated from underwriting activities by
the business. This is mainly because most short-term insurance products rates are set and priced
competitively, thereby making the premium rates insufficiently ample or flexible to eliminate
the loss aspects of the underwriting cycle. For example, according to an IPEC circular EC195
(2014) Altfin Insurance was suspended from writing new business and renewing policies. Its
suspension was due to its undercapitalization and failure to pay claims and the failure was
partly contributed by their premium undercutting strategy against rising claims forcing them
charge and accept motor business from brokers at 3% which was even below the 3.5% fleet
rate while charging 2% on fleet. The insurance industry measures underwriting profitability
using the ‘‘combined ratio,’’ the percentage of premiums that an insurance company spends on
claims and expenses, hence profitability is a major factor affecting return objectives.

Growth of surplus -

Providing growth of surplus is an important function of a short-term insurance company’s

investment operation, as this increases the opportunities of expanding the volumes in terms of
business that the insurance the company writes (Richeinstein, 2013). The risk taking capacity
of a Short-term insurance company is measured by its ratio of premiums to capital and surplus.
As a practice, this ratio is maintained between 2 to 1 and 3 to 1, and with many well capitalized
companies lower ratios used.

Short-term insurance companies can invest in quite a number of investment platforms so as to

obtain some level of diversification and these include investments, in common stocks, money
markets, convertible securities, and alternative investments which further aids in achievement
of growth of surplus (Kenton and Segal, 2020). However in order to achieve the growth the
investments’ return and the marketability characteristics should fit well within the short-term
insurance industry’s underwriting cycles and this is why growth of surplus is a major factor to
be considered when looking the return objectives (Richeinstein, 2013).

Liquidity requirements

Liquidity is a paramount consideration for all non-life companies, given the uncertainty levels
surrounding the cash flows recorded from the insurance operations (BrainScape, 2014).
Liquidity is also regarded as a necessary adjunct of a short-term insurance company’s variable
tax position and not just meeting cash flow needs (BrainScape, 2014). A common strategy
used by most short-term companies to increase tax exempt income is to liquidate portions of
their bond portfolios during periods of underwriting profits and also increase taxable income
during the periods of underwriting losses (Kisri, 2010).

Liquidity remains a necessity for casualty companies, providing portfolio flexibility under
changing tax, underwriting, and interest rate conditions. The insurance company has to do
several things that are related to the marketability and maturity schedule of its investments in
order meet its liquidity needs (BrainScape, 2014). For example given the short-term nature of
their liabilities it is more feasible to maintain a portfolio of short term securities, such as
commercial paper or Treasury bills, as an immediate liquidity reserve.

Furthermore, the short-term insurance company can hold a portfolio of readily marketable
government bonds which has various maturities and maintain a balanced maturity schedule to
ensure that there is sufficient rollover of the assets. That is the matching of some assets against
the seasonal cash flow needs (Richeinstein, 2013). Paying much attention to the maturity and
marketability supplement the limited risk tolerance and further modifies the return objectives
of Short-term insurance companies (Kisri, 2010).

Tax requirements

In most cases tax requirement will always be treated as investment constrains. Investment
constrains are those factors that tends to limit the investment options available to investors
(Ross, 2019). Investment income and capital gains are subject to differential tax treatments
and this depends on how returns of different investments are taxed hence the need to keep in
mind the tax environment the short-term insurance company is operating in (Forjan, 2018).
Over the years, short-term insurance companies’ investment returns have been taxed and the
results are very sensitive to the after tax return on most of the bond portfolio and to the tax
benefits, when they exist, of certain kinds of investment returns.

Tax requirements are not limited to investment return treatments only. For example in
Zimbabwe short-term insurance companies are required to withhold and remit insurance
commission tax which is calculated at the rate of 20% and value added tax to the Zimbabwe
Revenue Authority (ZIMRA, 2019).

Unique circumstances
When it comes to unique circumstances for the short-term insurance companies this has to do
with each insurance firm having its own circumstances that can be highly attributed to other
factors (Forjan, 2018). Most of these constraints are internally generated and highly signify
the insurance company’s special concerns (Forjan, 2018). The major contributing factors are
company size, surplus positions and ethical values. For example some companies may not
invest in companies that are in the alcohol business or weapon manufacturing. Such special
circumstances restricts some investments and should be considered when formulating the
investment policy statements.

Legal and regulatory factors

The insurance industry in general known to be highly regulated but short-term insurance
company’s investment regulation is relatively permissive. Legal and regulatory constraints are
external and usually assists in specifying which asset classes are permitted for investments and
any limitations on asset allocations to certain types of investment classes.

With short-term insurance company’s investments, classes of assets that are eligible and quality
standards for each class are specified. However when it comes to asset valuation reserves, a
short-term insurance company is not required to maintain an asset valuation reserve .Therefore
the surplus of a short-term insurance company reflects the full impact of increases and
decreases in the market value of stocks.

Investment time horizon

 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.

 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.

 In terms of common stock investments, casualty companies historically have

been long term investors, with growth of surplus being the primary return
objective of their portfolios’ stock portion.

 As noted earlier, realized gains and losses flow through the income statement.

 Currently, the long term equity investor status of the industry has been
modified by objectives related to current reported earnings that have in turn
led to some additional turnover in the common stock portfolio and more active
management of the total portfolio.