Except for firms dealing only in term life insurance, life insurance firms collect premiums during a person’s lifetime that must be invested until a death benefit is paid to the insurance contract’s beneficiaries. At any time, the insured can turn in her policy and receive its cash surrender value.
Discussing investment policy for an insurance firm is also complicated by the insurance industry’s proliferation of insurance and quasi-investment products.
Basically, an insurance company wants to earn a positive “spread,” which is the difference between the rate of return on investment minus the rate of return it credits its various policyholders. This concept is similar to a defined benefit pension fund that tries to earn a rate of return in excess of its actuarial rate.
If the spread is positive, the insurance firm’s surplus reserve account rises; if not, the surplus account declines by an amount reflecting the negative spread. A growing surplus is an important competitive tool for life insurance companies. Attractive investment returns allow the company to advertise better policy returns than those of its competitors. A growing surplus also allows the firm to offer new products and expand insurance volume.
Because life insurance companies are quasi-trust funds for savings, fiduciary principles limit the risk tolerance of the invested funds. The National Association of Insurance Commissioners (NAIC) establishes risk categories for bonds and stocks; companies with excessive investments in higher-risk categories must set aside extra funds in a mandatory securities valuation reserve (MSVR) to protect policyholders against losses.
Insurance companies’ liquidity needs have increased over the years due to increases in policy surrenders and product-mix changes. A company’s time horizon depends upon its specific product mix.
Life insurance policies require longer-term investments, whereas guaranteed insurance contracts (GICs) and shorter-term annuities require shorter investment time horizons.
Tax rules changed considerably for insurance firms in the 1980s. For tax purposes, investment returns are divided into two components: first, the policyholder’s share, which is the return portion covering the actuarially assumed rate of return needed to fund reserves; and second, the balance that is transferred to reserves.
Unlike pensions and endowments, life insurance firms pay income and capital gains taxes at the corporate tax rates on this second component of return.
Except for the NAIC, most insurance regulation is on the state level. Regulators oversee the eligible asset classes and the reserves (MSVR) necessary for each asset class and enforce the “prudent-expert” investment standard. Audits ensure that various accounting rules and investment regulations are followed.
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