On the Feasibility of Insurers' Investment Policies

Summary

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This article calls attention to a difficulty with insurers' investment policies that seems to have been overlooked so far. There is the distinct possibility that insurers cannot satisfy the demands of different stakeholders in terms of expected returns and volatility. While using the capital asset pricing model as the benchmark, this article distinguishes two groups of stakeholders that impose additional constraints. One is "income security" in the interest of current beneficiaries and older workers; the other is "predictability of contributions" in the interest of contributing younger workers and sponsoring employers. It defines the conditions for which the combination of these constraints results in a lack of feasibility of investment policy. Minimum deviation from the capital market line is proposed as the performance benchmark in these situations.

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Extract

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On the Feasibility of Insurers' Investment Policies

INTRODUCTION AND MOTIVATION

The performance of an insurer's investment policy is crucial for the company's success with its stakeholders, especially in the life and pension business. Therefore, it is astonishing that an important difficulty characterizing pensions seems to have been overlooked so far in the relevant literature. There is the definite possibility that no investment policy exists that simultaneously satisfies the demands of the different stakeholders in terms of expected returns and volatility. These stakeholders are shareholders, current beneficiaries of pension policies, and current contributors and sponsors. Using the shortfall concept in combination with the capital asset pricing model (CAPM), this article will show that their demands can reduce the set of insurers' feasible investment policies to measure zero, in particular when there is a drop in the funding ratio.

The importance of insurers' investment policy is documented by the experience of the past few years. While during the 1990s pension funds were able to please their contributors and sponsors with contribution holidays, the end of the bubble in 2000 has caused them to turn around, imposing benefit curtailments and contribution hikes. A whole generation of workers saw the very cornerstone of their lifetime economic plans shattered.

The plan of this contribution is as follows. Following the lead of Kraus and Ross (1982), the CAPM is used as the starting point in the section "The CAPM as the Point of Departure"; howev...

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