A small proprietary life insurance company with limited free assets writes both conventional with-profits and unit-linked without-profits business. Surplus arising on the with-profits business is distributed using the additions to benefits method. A non-executive director with an investment background has queried the high percentage of fixed-interest investments backing the with-profits liabilities and has suggested investing more in equities. Explain why this may not be possible.
Investing more in equities for a small proprietary life insurance company that writes both conventional with-profits and unit-linked without-profits business may not be feasible for several reasons:
Liability Matching: With-profits business typically involves long-term liabilities that require careful matching with assets. Fixed-interest investments, such as bonds, provide predictable cash flows and are less volatile than equities. This stability is crucial for meeting policyholder obligations, especially in a with-profits context where policyholders expect a certain level of guaranteed returns.
Policyholder Expectations: With-profits policies often come with guarantees or minimum returns. The use of fixed-interest investments helps ensure that the company can meet these guarantees. Increasing equity exposure could introduce more volatility, which may jeopardize the ability to meet these expectations, particularly during market downturns.
Regulatory Constraints: Insurance companies are subject to regulatory requirements regarding the types and proportions of assets they can hold. These regulations are designed to ensure that insurers maintain sufficient liquidity and solvency to meet their obligations. A shift towards equities may not align with these regulatory frameworks, especially if it increases the risk profile of the investment portfolio.
Risk Management: A higher allocation to equities increases the overall risk of the investment portfolio. For a company with limited free assets, this could lead to significant financial strain during periods of market volatility. The company may not have the capital buffer to absorb potential losses from equity investments, which could impact its financial stability.
Investment Strategy and Philosophy: The company may have a long-standing investment strategy that prioritizes capital preservation and steady income generation over higher returns associated with equities. Changing this strategy could require a fundamental shift in the company's risk appetite and investment philosophy, which may not be appropriate given its current business model and obligations.
Impact on Policyholder Benefits: If the company were to increase its equity exposure and subsequently experience losses, this could directly impact the bonuses or benefits paid to with-profits policyholders. This could lead to dissatisfaction among policyholders and damage the company's reputation.
Time Horizon: The time horizon for with-profits liabilities is typically long-term. While equities may offer higher returns over the long run, they also come with short-term volatility. The company must consider whether it can withstand potential short-term losses in pursuit of long-term gains, especially if it has obligations that require liquidity in the near term.
In summary, while increasing equity exposure may seem attractive for potential higher returns, the specific characteristics of with-profits business, regulatory requirements, risk management considerations, and the need to meet policyholder expectations make such a shift challenging and potentially detrimental to the company's financial health.