Why Life Insurers, Defined Benefit Plans, and Endowments Invest Differently

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Why Life Insurers, Defined Benefit Plans, and Endowments Invest Differently
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Despite the large and seemingly meaty title, this will be a short piece. I class these types of investors together because most of them have long investment horizons. From an asset-liability management standpoint, that would mean they should invest similarly. That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true. In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so. So, why do they invest differently? Two reasons: internal risk management goals, and the desires of insurance regulators to preserve industry solvency.

Let’s start with life insurers. Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges. The riskier the investment, the more capital the insurer has to put up against it. After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch. Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

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DB plans don’t have regulators that care about investment risks. They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15 years. Back in the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct. (Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds. Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets. Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor that has to make future payments. They are free to invest as they like, and probably have the highest degree of variation in their assets as a group. There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.] You might think it would be smart to have the present value of 3-5 years of expenditures on hand in bonds, but that is not always the case. In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary. If you have thoughts on the matter, you can share them in the comments.

Life Insurers

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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