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TRANSACTIONS OF SOCIETY OF ACTUARIES 1967 VOL. 19 PT. 1 NO. 55 THE ACTUARY'S ROLE IN INVESTMENT STRATEGY FOR NEW LIFE INSURANCE COMPANIES THURSTON P. FARMER, JR., AND ANTHONY J. HOUGHTON INTRODUCTION T m~ investment of life insurance company funds produces the investment income which is one of the major elements affecting the cost of insurance. The task of investing these funds is handled in large companies by a separate investment department, which may include economists, security analysts, city and farm mortgage appraisers, and legal advisers. These large companies may accept direct placement of bonds amounting to millions of dollars and finance large office buildings, housing projects, and shopping centers, in addition to making the more usual investments in government and publicly offered corporate bonds, mortgages on single-family homes, preferred stocks, and common stocks. As the size of the company decreases, the scope of the possible investments decreases. Occasionally the company's actuarial department may be involved in investment decisions, but usually it only supplies technical evaluation of complicated financial proposals. The Society of Actuaries includes material in the study syllabus concerning investments, but to most actuaries who remain in actuarial positions it is only used as background material. In other countries actuaries play a much more important role in the actual investment of company funds. In the United States this has not been the tradition, and, because of the experts available to large companies, the need for actuaries to take a more active role has not been evident. Because of this tradition the actuary often does not participate fully in basic investment decisions, even when there is a lack of other qualified personnel. This paper discusses the special problems of new and, as a class, the smallest life insurance companies. For the purposes of this paper a new company is defined as one less than five years old. This paper will suggest the reasons why an actuary should play a role in the over-all investment policy of the new company and what some of his duties should be. It will not cover all situations or suggest strategy for all situations, since one of the primary duties of an actuary in a specific instance will be to identify the company's specific financial characteristics and see that the investment policy is consistent with the company's financial situation. 275 276 THE ACTUARY S ROLE ~ INVESTMENT STRATEGY OBJECTIVES O1 ~ AN INVESTMENT PROGRAM The objectives which guide a life insurance company in selecting specific investments differ from the investment objectives of an individual, an investment company, or another kind of corporation. Some of the considerations involve achieving positive advantages and others involve avoiding disadvantages. Life insurance company investments, because of the nature of the business and the laws and regulations promulgated by the various states relating to legal investments and the valuing of such investments in the annual statement, sometimes appear to place more weight on avoiding the disadvantages than on achieving the positive advantages. Positive objectives are (1) high yield, (2) possibility of capital gain, and (3) useful by-products by reason of investment. The objectives which relate to freedom from disadvantages are (1) safety of principal--avoidance of capital loss; (2) liquidity--marketability; (3) stability; (4) ease of ascertaining value; (5) economy of obtaining, maintaining, and disposing of investment; (6) legality; and (7) minimizing tax and reserve requirements. Most of these objectives are well known and easily understood. Naturally, a life insurance company wishes to acquire an investment with a high yield that may increase in value and that will enhance its reputation. However, the investment must be one allowed by the investment laws and regulations of the state insurance code, and it should merit the confidence of the policyholders and stockholders. It should be reasonably inexpensive to administer, and it should have a ready market where its value can be established and the investment traded without undue sacrifice. Since it is desirable to avoid undue surplus fluctuations, the stability of the value to be shown in the annual statement is important. It is obvious that few investments have all the favorable features and none of the unfavorable ones. Therefore, the company must modify its objectives so that it best meets the investment requirements. The legal requirements, of course, are overriding, and all other objectives are subject to the investment's being legal. Let us consider how these objectives apply to certain types of investments. United States government bonds.--none of the disadvantages are present. They are safe, liquid, and marketable. They can be bought without restriction as to size. They are not subject to the criticisms of undue risk or favoritism in making the investment. Their value is stable since they are always amortizable, and their value is always ascertainable. They do not require a Mandatory Securities Valuation Reserve. However, the yield is normally less than that of other stable investments. THE ACTIYARY~S ROLE IN INVESTMENT STRATEGY 277 State and municipal bonds.--the bonds in this category vary widely in degree of safety, liquidity, marketability, and stability. As a whole, yields on this category of bonds are lower than those on other bonds because interest on them is exempt from federal income tax. The attractiveness of tax exemption varies among life insurance companies, but the attractiveness is generally less than that for other types of corporations or individuals in a high income-tax bracket. Further, the exemption is of no vmue to companies incurring operating losses, and many new companies are in this category. The Mandatory Securities Valuation Reserve requirement is relatively low for high-quality state and municipal bonds. Sometimes a factor in the purchase of state and municipal bonds is the expectation of a useful by-product, that is, public relations in the particular state or municipality. Corporate bonds.--high-quality corporate bonds have few disadvantages. However, many states impose restrictions on the percentage of assets that may be invested in any one corporate issue, such that the maximum investment by a new life insurance company in any one issue is usually quite small. Furthermore, many industrial bonds are privately placed in relatively large amounts, so that smaller companies may not have access to many issues. The Mandatory Securities Valuation Reserve requirement is relatively low for high-quality corporate bonds. The yield is generally better than that on United States government bonds. Preferred stocks.--preferred stocks avoid most of the disadvantages to some degree. Now that preferred stocks in good standing are valued at cost, there is a stability in the statement value. In some cases there is a tax advantage; however, this is of no value to a new company which is incurring an operating loss. The Mandatory Securities Valuation Reserve requirement is moderately severe. Usually the yield is fairly high. Occasionally a preferred stock will have a feature that allows conversion to common stock. In this case, the possibility of a capital gain is present. Common stocks.mpublicly traded common stocks are marketable and easily valued. The possibility for a substantial capital gain or capital loss is present. There are often legal limits on the percentage of assets which may be invested in common stocks as a class and in individual companies. The ultimate yield rate is not determinable since the price and/or dividend can change from time to time; however, the current yield is apt to be fairly low. The attractiveness of common stocks is the possibility of capital growth in addition to yield. The Mandatory Securities Valuation Reserve requirement represents a problem which is discussed in detail elsewhere. Mortgages.--This type of investment has the advantage of a high 278 THE ACTUARY'S ROLE IN INVESTMENT STRATEGY yield and the possibility of a useful by-product if the mortgage is on a property within the market area of the life insurance company. The disadvantage is the administration cost of inspecting and servicing if only a small portfolio is maintained. Refinancing and reinvestment of principal repayments as well as interest is a problem which must be considered. There are no Mandatory Securities Valuation Reserve requirements in connection with mortgage investments. Real estate.--this type of investment may have all the positive advantages, but it has most of the disadvantages as well. The yield is less certain than it is with other investments unless the real estate is under long-term lease to a stable organization. The possibility of capital loss is present, and the administration requires more professional and technical assistance than other investments do. Valuation for annual-statement purposes is more complicated and may require periodic appraisals in order to determine the admitted asset value. There are no Mandatory Securities Valuation Reserve requirements in connection with real estate investments. STATE REGULATION OF INVESTMENTS Each state passes laws and makes regulations for domestic life insurance companies which regulate the investment of their funds. The laws usually specify certain classes of investments in which life insurance funds may be invested and impose various quantitative and qualitative restrictions for each class. Both the aggregate amount which may be invested in a class and the amount which may be invested in a specific issue are limited, usually to a percentage of the life insurance company's admitted assets. Certain investments, such as United States government direct obligations, are not limited in amount. An example of the investment regulations 1 for industrial bonds is: a) The corporation shall be incorporated under the laws of the United States of America or any state of the United States of America; b) The corporation shall have tangible net worth of not less than $500,000; c) No such obligation of the corporation has been in default as to principal or interest during the S years preceding the date of investment, but the corporation need not have had obligations outstanding during that period and need not have been in existence for that period, and obligations thus acquired may be newly issued; d) A company shall not invest more than 33t per cent of its admitted assets in industrial bonds; and t) A company shall not invest more than 2 per cent of its admitted assets in the obligations of any one such corporation. 1 Excerpt from Illinois Insurance Code, Ch. 73 tc737.9a. THE ACTUARY~S ROLE IN INVESTMENT STRATEGY 279 A new company with $1,000,000 in assets could invest no more than $333,333 in corporate bonds and no more than $20,000 in the bonds of one corporation under the law stated above. Because of similar limits on public utility bonds, municipal bonds, individual conventional mortgages, and so forth, a new life insurance company must make a great many small investments if it wishes to invest in these classes of investments. Since many new life insurance companies desire to limit their initial investments to a relatively small number of issues for economy and simplicity, United States government bonds which do not have restrictions on amounts are favored. INVESTMR.~/T PERSONNEL In many large companies the board of directors initiates or approves general investment guidelines and perhaps appoints a committee of directors which approves specific investments. Often large companies elect to their board of directors businessmen with financial backgrounds who are knowledgeable in corporate investments and economics. The board of directors of smaller companies is less likely to have members who can give guidance to the insurance company's personnel in investing the company funds. A new life insurance company usually has no officer who is experienced in life insurance investments and probably could not justify the cost of carrying such a man until the volume of funds to be invested increases considerably. This may leave the investment of the funds to a chief operating officer who may be experienced in agency matters or homeoffice operations but often is not experienced in life insurance company investing. Occasionally such a chief operating officer has been successful in his personal investments and has confidence that his personal experience has prepared him to invest the life company's funds. Other executives who are responsible for the investment of funds may rely on the advice of stock- and bond-brokers, corporate trustees, bankers, and even occasionally consulting actuaries. Some new life insurance companies turn their entire investment-management function over to corporate trustees who determine the investments, contact the brokers, hold the bonds, collect the coupons, prepare the annual-statement exhibits, and report periodically to the company. The investment of life insurance funds involves some principles which are common to other types of investments, but there are also special considerations which are unique to life insurance companies. In addition, an investment which is a good investment for Company A may not be a good investment for Company B. For example, it might be reasonable for 280 THE ACTUARY~S ROLE IN INVESTMENT STRATEGY an investor to sell a bond with a low nominal yield at a market price well below the purchase price in order to purchase another bond that over the life of the bond will produce greater income. But for an insurance company with low surplus the capital loss, to the extent it cannot be offset against the Mandatory Securities Valuation Reserve, can be very embarrassing. Many times, if a bond is amortizable, it is better to retain the bond and accept the lower yield. Many of the people who are now investing the funds of new life insurance companies are not aware of the objectives of life insurance investing, the effect of the Mandatory Securities Valuation Reserve, and the effect of income taxes on life insurance companies. Other people who are knowledgeable in life insurance are not trained or experienced in corporate investing. This condition may be recognized by some executives of new small companies, but a satisfactory solution is not evident to them. It would seem that the actuary, with his great knowledge of life insurance operations and regulations, is in a position to be of great assistance, even though his knowledge of investment matters is of a general nature. ADMINISTRATION OF INVESTMENT PORTFOLIO The life insurance company must collect the coupon periodically for each bond. When the bond is purchased, the company must prepare one or possibly two schedules (NAIC, IRS) showing amortization of premium or accrual of discount. The company must check the financial press for notice of calls and so forth. The company must make individual calculations of amortization of premium or accrual of discount and accrued interest if the bond is sold in the middle of the year, record all information on a bond-record card and in the accounts, and prepare the appropriate information in the investment schedules of the annual statement. Naturally, the more bonds one has to deal with, the more expense this job entails. In addition, the cost of doing this work for a $10,000 bond is as great as the cost of doing it for a $100,000 bond. Therefore, the company which has a great many small bonds will have a relatively high investment expense. The administration of mortgages is also quite expensive per unit of investment unless one has a large mortgage department. Before placing a mortgage, a lender must have an appraisal, make sure that there is adequate insurance, obtain a credit report on the borrower, and so on. Upon making a mortgage, the lender usually must prepare an amortization schedule. Periodically it must collect the mortgage payment and separate the payment into principal and interest. In the event the borrower defaults on his mortgage payments, the company must institute foreclosure proceedings and eventually may be forced into assuming THE ACTUARY~S ROLE IN INVESTMENT STRATEGY 281 ownership of the property. All these things require special knowledge and cannot be handled effectively and economically as a side line. Ownership of the home-office building in which the remainder of the building is sublet to tenants also involves many problems. A company may have to replace tenants periodically and assume the many other problems which are a part of office-building management. Further, ownership of a building may restrict the life insurance company in its plans for expanding or moving its home office. Common stock purchases require considerable skill in selecting the proper stocks, knowledge of the long- and short-term prospects of the issuing company, knowledge of the stock market itself, and knowledge of whether the life insurance company is depending upon a reasonably high yield from the investments or can sacrifice yield now to obtain a capital gain later on. Since common stocks require constant supervision, the effort spent on supervising any common stock portfolio might be excessive for a small company which is only investing a relatively small portion of its assets in common stocks. Some of the tasks of administering investments might be turned over to people who specialize in certain areas. For example, a bank or trust company might act as a custodian for bonds or stocks, collect the coupons, and prepare a schedule of the bonds and stocks held periodically. Other banks and trust companies might accept the responsibility of actually making the investments of bonds and stocks for a higher fee. A mortgage correspondent might do the work of a mortgage department, and it is possible to get packages of mortgages which are FHA-insured through a correspondent. If the life insurance company owns a home-oi~ce building which it wishes to rent or lease, a professional office-building management team might handle that for a fee. A stockbroker might be willing to give advice and counsel on the purchasing of common stocks and bonds. In many cases, while these people may be able to do a good job, the cost of providing their services will make the investment expenses quite high. Because of the many problems associated with other types of investments, United States government bonds are quite popular with small companies. These bonds can be bought in large amounts, they are safe, they have no Mandatory Securities Valuation Reserve requirement, and they are acceptable as deposits by all state insurance departments. Unfortunately, however, they do not have the highest yields. In summary, the cost of administration can be quite expensive, and a new investment line, such as home mortgages, should not be initiated without careful consideration of the ability to make substantial future 282 THE ACTUARY'S ROLE IN INVESTMENT STRATEGY investments in this category, no matter how attractive the present investment opportunity appears. MANDATORY S~cuRrrrES VALUATIO~ RESERVE One special requirement which should be considered in setting investment policy is the Mandatory Securities Valuation Reserve (MSVR). The MSVR is a special liability required of life insurance companies to be held as a buffer against fluctuations in the value of bonds and stocks. As of December 31, 1956, it consists of three components: (1) bond and preferred stock reserve component, (2) common stock reserve component, and (3) temporary excess reserve component. No portion of the reserve relates to mortgages, real estate, policy loans, or any assets other than bonds and stocks. In discussing the effect of the MSVR on investment policy, the temporary component will be ignored, since it will not affect permanent investment policy. Bond and preferred
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