The role of investment optimisation within the insurance cycle

When it comes to investment optimisation, three factors namely risk, return and time period play a major role within the insurance cycle. How these factors affect optimisation will all depend on the liability duration of the insurance company.

The investment objectives and constraints in the insurance industry are determined by whether a company is involved in short-term or long-term insurance. Long-term insurance companies deal with liability requirements that are far less volatile then those experienced in short-term insurance. Short-term insurance companies have to contend with unpredictable external factors, such as motor vehicle accidents or theft, and sometimes natural disasters.

Insurance companies have a fiduciary responsibility to their policyholders once they incur a loss that has been insured by them. This is why investment risk exposures are kept to either low or moderate. The competitive pressure that exists between the large numbers of board based insurance companies in South Africa can have an impact on premium pricing as premiums are affected by the probability of loss, as well as the investment returns earned by the company.

External factors that impact on the economy

Investment returns in South Africa’s insurance industry have had to contend with severe local and global economic factors attributable to rising premium costs while currency weakness and an exchange rate of over nine rand to the dollar has impacted the cost of imported supplies dramatically. SARB’s inflation target range of between 3% - 6% and South Africa’s inflation rate of around 10% have also resulted in increased costs.

South Africa’s high motor accident rate, weak currency and high inflation have furthermore made the cost of vehicle parts and repairs very expensive. Crime is also a constant plague and has resulted in frequent losses by the insured.

Generally the global trend is for short-term insurance companies to invest insurance reserves in relatively safe bonds. In turn, the bonds provide the required income to pay claims. However, the South African market has experienced an inverted yield curve over the past few years, resulting in money market yields often outperforming bond yields. Many South African companies therefore now have their investment portfolios tipping the scales toward money market instruments rather than bonds.

For many short-term insurers, an increasing claims incurred book has meant they invest higher volumes of cash in money market, because they are readily liquid investments. Unfortunately, this means that they lose out on greater investment return they could gain by investing in longer dated instruments. Due to the nature of short-term insurance and the possibility of unexpected losses, liquidity remains a key factor in terms of asset allocation. Another reason short-term insurers value liquidity, is because it can switch between taxable and tax exempt investments based on whether underwriting activities are generating profits or losses.

Due to the potential growth that exists in the equity market, some short-term insurance companies invest their internal capital and surplus funds in equities. These companies are generally able to grow larger surplus through their returns, which gives them the competitive edge over their competitors. We may now find that more and more short-term insurers will have a tendency to look at their capital portfolios with a total return objective in mind, in order to increase the surplus funds over time.

By Shanil Rabilal, Investment Operations Manager, Centriq Insurance