Question

Discuss carefully: What would be the differences in characteristics of the financial assets that would appeal to pension funds versus those that would appeal to insurance companies?

Answer 1

Financial assets for Pension Funds need to be carefully managed to ensure that retirees receive promised retirement benefits. For many years the fund managers chose relatively risk free assets like government securities, investment-grade bonds, and blue-chip stocks. Changing market conditions and the need to maintain a high-enough rate of return have resulted in pension plan rules that allow investments in diversified and inclusive asset classes. These are some of the most common investments to which pension funds allocate their substantial capital.

1) U.S. Treasury securities and investment-grade bonds are still part of pension fund portfolios. Investment managers seeking higher returns have expanded into high-yield bonds and well-secured commercial real estate loans.

2) Portfolios of asset-backed securities, such as student loans and credit-card debt, are newer tools intended to boost overall returns.

3) Equity investments in U.S. blue-chip common and preferred stocks are a major investment class for pension funds. Larger funds, such as CalPERS, self-manage portfolios. Smaller funds invest in institutional versions of the same mutual funds and exchange-traded funds (ETFs) as individual investors.

4)  Private Equity represents managed pools of money invested in the equity of privately held companies with the intention of eventually selling the investments for substantial gains.

5) Long-term real estate investments are in commercial real estate, such as office buildings, industrial parks, apartments, or retail complexes. The goal is to create a portfolio of properties that combine equity appreciation with a rising stream of inflation-adjusted income to balance the ups and downs of the markets.

6) Infrastructure investments are a small part of most pension-plan assets, but they are a growing market of a diverse assortment of public or private developments involving power, water, roads, and energy. Public projects experience limitations due to budgets and the borrowing power of civil authorities. Private projects require large sums of money that are either expensive or difficult to raise. Pension plans can invest with a longer-term outlook and the ability to structure creative financing.

On the other hand, Insurance companies tend to invest the most money in bonds, but they also invest in stocks, mortgages and liquid short-term investments.

Insurance is the redistribution of risk. An insurance company has to charge each client enough for their insurance to pay off the probable loss, plus some additional amount calculated by its actuaries to take into account less probable outcomes and finally another amount that represents the desired profit. An insurer could take premium money received and just and put all the money in safe investments. However, that would be enough to run the business profitably. Investing the premiums helps in increasing the insurance company's profits and makes it possible for the company to lower its premium amounts, making its policies more attractive to clients.

1)  For life insurance companies, stock market investments represent around 5 percent of total holdings. Property and casualty insurance companies usually invest around 30 percent of holdings in common stocks. An insurance company has to know with a high degree of certainty that overall in any given year they're not going to absorb an unsustainable loss; therefore stocks can only represent a relatively small portion of their investment portfolios.

2) The appeal of bonds is that they provide a much more predictable future cashflow, but also investment grade bonds return markedly less on average than the long-term return of the stock market. The two investment classes are only weakly correlated.

3) Another relatively low risk that's uncorrelated in other words, an investment whose returns are independent - investment in the mortgage market.

4) Highly liquid short-term investments and cash, totaling about 5 percent of investments for life insurers and about 10 percent for insurers in the somewhat more volatile property and casualty business.

5) Insurance companies invest in areas that include derivatives, contract loans, securities lending, real estate and preferred stock. But all these areas together total only about 10 percent of life insurance company investments and slightly more than that for property and casualty insurers.