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On one hand, the promulgation of these regulations and policies provides the insurers
with more investment tools and more opportunities to maximize the investment
1
Thanks Professor Hao Yansu for his great support.
*
Postgraduate Student of Insurance School, Central University of Finance and Economics E-mail:
giolla@163.com
*
Professor of Insurance School, Central University of Finance and Economics, Director of China
Insurance Market Research Center
returns. Meanwhile, it is a challenge for the young domestic insurers because it calls
for an adjustment of investment strategy under the new policies—they must analyze
the returns and risks of both newly added investment vehicles and former vehicles
comprehensively, and then evaluate the optimal investment portfolios.
The purpose of this research is to provide theoretical and technical supports with
insurance investment in China, the largest emerging insurance market. Meanwhile,
other emerging insurance markets like India and Brazil also face the same situation
that they are all experiencing rapid development, which highly requires the
improvement of investment efficiency. This paper may also be used as a reference for
other emerging insurance markets.
2.1.1 Deposit
When China domestic insurance industry resumed operation in 1980, little attention
was paid to investment management, so insurance funds could only be deposit in
banks. Since then, deposit has been the primary insurance investment tool, as at the
end of 2006, deposits of insurance funds reached 562.8 billion Yuan, accounting for
33.2% of the total funds. Deposit is highly security and liquid, but it is sensitive to
macroeconomic policies and its interest rate is lower than securities. Since 1996, there
has been a huge loss arising from difference of interest rate in Chinese life insurance
companies as China central bank has lowered the interest rate eight times. Till now
the interest loss is still a heavy burden for these companies.
2.1.2 Bonds
The CIRC promulgated and put into effect the “Enterprise Bonds Investment
management of Insurance Capital “on March 30, 2003. Then insurance companies
began to invest in enterprise bonds, but the bonds scope is strictly limited in central
enterprise bonds such as railway construction, construction of power et al, as well as
bonds whose credit rating are at least AA. The investment amount of enterprise bonds
is subject to not exceed 20% of the total assets of the company.
On August 21, 2005 CIRC launched “Interim Measures for bond investment
management of insurance capital”. The official document approved that insurance
companies could determine the proportion of investment in Treasury bond
independently whilst the maximum proportion of investment in enterprise bonds
increases from 20% to 30%. Therefore insurance industry increased the bonds ceiling
substantially.
Due to its security and liquidity, which comply with the principles of insurance
companies’ investment strategies very well, bonds become the most important
investment tool for insurance industry. The bond accounts of China insurance industry
have grown rapidly. The amount of bond investment in 1999 was 80.5 billion Yuan;
however the amount rose to 944.6 billion by the end of 2006. And insurance
companies become the second largest institutional investor in bond market.
With the continuous growth of total proportion of bond investment, the investment in
Treasury bond has reduced in spite of its advantages in stability, liquidity and tax
benefits. Compared with other high-yield bonds, Treasury bond becomes less
attractive so that insurance companies hold Treasury bond with purpose of security
rather than profits.
In October 1999 CIRC and China Securities Regulatory Commission (CSRC) jointly
issued an announcement which officially approved insurance companies to invest in
security funds to indirectly enter the capital market.
By the end of 2001, attracted by the bull market, the security investment funds of
insurance industry increased from 1.5 billion Yuan to 200 billion Yuan, and the
average increasing rate reached 20%. But from the end of 2001, China's capital
market had started a long and painful period of adjustment.
On February 7, 2005, the CIRC approved that insurance companies could invest in
stock, and the amount that has deducted the premium income of variable life and
universal life products shouldn’t exceed 5% of the total assets of last year.
The main characteristic of stock is its high risk: on one hand, the principal can not be
returned; on the other hand, the prices in secondary market fluctuate all the time, and
the influence factors of the prices are unpredictable and speculative.
Entering into long-term infrastructure construction has a long history for insurance
funds around the world. In Japan's post-war recovery period, the insurance companies
found by some large financial groups had more interests in infrastructure projects. By
the end of 1986, insurance funds that invested in real estate and city construction
reached 20.1845 trillion yen, so the insurance companies had made great
contributions to Japan in the post-war economic recovery.
On August 18, 2004, CIRC and Central Bank of China jointly issued the "Foreign
exchange insurance funds management(draft)", and allowed the foreign exchange
funds of domestic insurance companies to invest in overseas bond markets, with the
purpose of opening a new channel for the 10 billion U.S. dollars foreign exchange
funds of China insurance industry. International experience shows that the global asset
allocation capability is the core competencies of the insurance industry. Currently,
there are no substantive overseas investments of China insurance industry, overseas
investment portfolio and risk control strategies have to be explored.
12.81%
25.47%
With the reform of economic system and development of capital market, the portfolio
of insurance investment is changing. Let us have a look at China Ping An Insurance
Company investment portfolio for the last three years. We can also find the same
trend of the whole insurance industry that bank deposits kept decreasing, while the
proportion of bonds, Security investment funds and stocks increased year by year.
100%
80%
60%
40%
20%
0%
2004 2005 2006
China insurance company's investment yield is below this level. From 2001 to 2004,
the insurance industry overall investment rate of return continues to decline and
reached the minimum rate 2.40% in 2004, far less than the Supervision Index 3%.In
2005 and 2006, the recovery of return is mainly dependent on the prosperity of capital
market.
7.00%
5.80%
6.00%
5.00%
4.30%
3.89%
4.00% 3.60%
3.14%
3.00% 2.68%
2.40%
2.00%
1.00%
0.00%
2000 2001 2002 2003 2004 2005 2006
3 Literature Review
Harry Markowitz initiated the work on portfolio management problems. He
developed a portfolio theory according to which the mean and the variance of the
portfolio return are sufficient measures of the uncertainty for the portfolio selection
purposes.
Since its introduction in the 1950s the theory has been utilized in several applications.
Most of these applications are static allowing only one time period, and then dynamic
models are developed. However, dynamic models have faced resistance due to the
computational difficulties and vast data requirements as well as the sensitivity of the
errors in input parameters.
Many researchers have used the portfolio theory to analyze investments of insurance
funds. Lambert and Hofflander (1966) used Markowitz's portfolio theory in research
of the investments of the property insurers. Forst (1983) considered the structure of
the insurance funds, and analyzed the feasibility of using modern portfolio model in
the research of life insurers. Dominique (1989) used diffusion analysis to look into
underwriting profit and investment income. Cariño and T. Kent(1994) present an
asset/liability model for a Japanese Insurance Company. They use multistage
stochastic optimization to determine an optimal investment strategy that incorporates
the uncertainty in future assets and liabilities as well as complex regulations imposed
by Japanese insurance laws and practices.
In China, the study of insurance investment remained at the very early stage where
model assessment is much more done than empirical studies. Shan Mingli (2000)
proposed the main problems of the application of Maikowitz Portfolio Theory in
China , as well as presented their ideas of improvements for the optimal investment
portfolio model. Yang Guiyuan and Tang Xiaowo (2001) studied how to choose the
securities investment portfolio and established a correlation model. Guo Cunzhi(2001)
discussed the application of modern portfolio in securities choosing and studied the
prospects of this theory in the present stage in China, and put forward relevant
proposals. Rong (2001), analyzed the gross income and risks of insurance companies,
and improved the theory of the insurance investment model with an optimal
investment ratio formula. Cui (2004), according to CAPM theory, constructed a
minimum risk investment portfolio under a given profit.
Portfolio Theory (Markowitz, 1952) holds that all the investors are risk-averse. And
investors expect to gain the maximum return under certain risk or suffer minimum
risk under certain expected return. It means the investor’s portfolio must seek the
balance between targeted risks and expected return in order to minimize the risk while
pursuing the maximization of return.
4.1.2 CML
CML is a line used in the Capital Asset Pricing Model to illustrate the rates of return
for efficient portfolios depending on the risk-free rate of return and the level of risk
for a particular portfolio.
The CML is derived by drawing a tangent line on the intercept point on the efficient
frontier where the expected return equals the risk-free rate of return. And CML is
considered to be superior to the efficient frontier since it takes into account the
inclusion of a risk free asset in the portfolio. The capital asset pricing model (CAPM)
demonstrates that the market portfolio is essentially the efficient frontier. The formula
and figure of CML are as below.
R0 Efficient Frontier
σ
0
Figure 4: Capital market line
R=R0+ [(Ri-R0)] × σ
Ri denotes the expected return of risk assets, R0 denotes return of the risk-free asset, R
denotes expected return of portfolio and σ denotes the portfolio’s risk.
Currently, China insurance funds are used in bank deposits, bonds, stocks, securities
investment funds, insurance policy loans, indirect investments in infrastructure
construction and overseas investments. We set bank deposits be the risk-free
investment for insurance company, and take treasury bonds, enterprise bonds, stocks
and securities investment funds as risk assets.
As the insurance funds have not yet been used in the infrastructure investments and
overseas investments, this study does not include these two investment channels.
Bonds investments include financial bonds, subordinated bonds, convertible bonds
etc. To simplify the study, we only study more representative treasury bonds and
enterprise bonds. Hence some errors may exist because of the ignorance of some bond
varieties.
We suppose there are N+1 investment assets, including N risk assets and one risk-free
asset. Then the return of the portfolio is
N N
R=r+ g α 0 r0+g ∑αiri α 0 + ∑αiri =1
i =1 i =1
N
E(R)= E(r)+ g α 0 r0+g ∑αE(r
i =1
i )
i
N N
Var(R) = Var(r)+2g ∑α Cov(r,
i =1
i ri) + ∑g 2αiαjCov(r i, rj)
i, j=1
Insurers generally expect to get maximum total return and minimum total risk.
However, the amount of risk they will take on is positively correlated to expected
return. So Insurers will balance the total return and total risk by their risk preference
to choose a portfolio with risk assets and risk-free assets, in order to maximize the
satisfaction of the proceeds, and meet the demand for insurance payments, while
minimizing its total risk. Therefore we are going to establish an insurance portfolio
model with minimum risks under certain rate of return to calculate the optimal
portfolio of China insurance companies. That is:
N N
min[Var(r)+2g ∑αiCov(r, ri) + ∑g 2αiαjCov(r i, rj) ]
i =1 i, j=1
N
s.t. E(r)+ g α 0 r0+g ∑αE(r
i =1
i i) =E(R)
N
α 0 + ∑αiri =1
i =1
α 0 , αi ≥0,(i=1,2,…,N)
To calculate the optimal portfolio, we need to solve the optimal values of α 0 and αi
(i=1,2,…,N). The insurance portfolio model above is a kind of nonlinear programming
problem, so we can use Kuhn-Tucker conditions to solve it. We will take the nonlinear
programming problem below as an example.
Min f(x)
gi(x)≤0 (i=1,2,…,m)
s.t.
hj(x)=0 (j=1,2,…,l) Function f(x), gi(x) and hj(x) all have first continuous partial
derivatives.
Because insurance company's profits are mainly derived from investment profit and
underwriting profit, so this study set underwriting profit be insurance company profits
minus investment profits. So we set underwriting profit margin=underwriting profit/
(underwriting income-change in unearned premium reserves-change in long-term
unearned premium reserves).
Stock 5%
We bring the values of the independent variables to the insurance investment portfolio
we established:
4 4
Min [0.003210+2×0.65 ∑αi Cov (r, ri) + ∑0.65 2 αiαj Cov (ri , r j ) ]
i =1 i , j=1
4
s.t. -7.0%+0.65×3.052% α0 +0.65 ∑αi E (ri ) =E(R)
i =1
N
α0 + ∑α i =1
i =1
So we have a new model with the added constraint conditions, and the solution of this
model is the efficient portfolio of Ping An insurance Group.
4 4
Min [0.003210+2×0.65 ∑αi Cov (r, ri) + ∑0.65 2 αiαj Cov (ri , r j ) ]
i =1 i , j=1
4
s.t. -7.0%+0.65×3.052% α0 +0.65 ∑α E(r ) =E(R)
i =1
i i
N
α0 + ∑α i =1
i =1
α2 ≤39.37%
α3 ≤19.69%
α4 ≤6.56%
α0 , αi ≥0,(i=1,2,3,4)
This model is a kind of nonlinear programming problem with constraint conditions, so we can
use Kuhn-Tucker conditions to solve it. We input the data into Excel’s programming function,
and get the efficient portfolio as follow:
Table 7: Efficient Portfolio of Insurance Funds
Table 7 shows the total risk increased with the total return. Bank deposit proportion
reduced significantly when the total investment return increased, however Treasury
bond proportion increased with the total return significantly. Enterprise Bond and
Security Investment Fund changed a little, for example the proportion of enterprise
bond is about 21% in various efficient portfolios. The restraint condition of stock is
less than 6.56%, whereas the proportion of stock has reached the ceiling when the rate
of return increases to 4, so the proportion of stock is unable to rise.
Optimal portfolio can peak the slope of CAL, which means the reward-to-variability
ratio reach the maximum too. And the function of CAL’s slope is:
Si=[E(ri)-r0]/ σi
E(r)
E(r)=4.5 σ =6.6
3.052%
σ
0
By calculating the slope of these CALs, we know that when rate of return is 4.5%,
variance is 44.408, and the slope of CAL reaches the maximum 0.23. So we can
conclude that when total return is 4.5%, the portfolio meet the two requirement of
high return and low risk. Let’s compare this optimal portfolio to Ping An group’s
actual portfolio.
In the same way, we can deduce the optimal portfolios and actual portfolios of China
Life Insurance Company and PICC Property (Casualty) Company.
Table 9: Actual Portfolio of China Life Insurance Company 2004-2006
5 conclusions
From the comparison of practical portfolio and theoretical investment portfolio of
these three companies we can see that:
5.1 Analysis of deposits and treasury bonds investment of China insurance companies
The investment funds of insurance companies are mostly liabilities to the insured,
because the funds must be paid to them after the insurance accidents. Therefore, to
maintain an adequate solvency, insurance investment must strictly follow the principle
of security. So the majority of domestic insurance company's funds mainly invested to
the bank deposits and treasury bonds. But the rates of return of them are lower than
other securities correspondingly. If domestic insurance companies decide to raise the
yield of investment, it is necessary to increase the investment of enterprise bonds and
other high return securities.
5.2 Actual investment proportion of enterprise bonds is lower than the theoretical one
An important reason for the low proportion of securities investment funds is that
China securities investment funds market is still in its early stage of development,
which makes the insurance companies puzzled by high market risk and fluctuations of
rates of return—the performance of market from 2000 to 2006 is the best proof.
In China, policy influenced the stock market apparently, so systematic risk in stock
market is significantly higher than that in other mature stock markets. That is even the
nonsystematic risks can be transferred, the investors will have to take on plentiful
systematic risk.
Furthermore the insurance funds can directly invest in stock market, so insurance
companies do not need security investment funds to help them invest in stocks. This is
another reason for the low percentage of security investment funds.
5.4 Stock investment grows rapidly and approaches the policy ceiling
After the exploration in 2005, China insurance funds started to increase the scale of
direct investment in stock in 2006. By the end of August 2006, the investment
proportions of stocks get to 49.903 billion Yuan, and accounted for 3.14% of the total
investment funds. In 2006, stock investment of PICC was 7.9 billion Yuan, accounting
for 10.12% of its total assets. The proportion of stock investment of New China Life
insurance Company and Tai kang Life insurance Company has nearly reached the
ceiling.
China insurance companies have to increase investment return to meet rapid growth
of the total assets. And in the last two years, lots of banks, telecommunications and
other large capitalization stocks have listed, therefore the insurance industry will
continue to invest in the stock market substantially.
Although the good news from the stock market is really exciting, the insurance
industry should be conscious of the risks of the stock market. In the past four years,
the bear market has brought many losses to institutional investors, so the insurers
should control the amount of stock investment. It is reported that “regulation of
insurance venture capital investment management” has been draw up already.
It can be seen from table 8, 9 and 10, the sum of deposit and Treasury bond accounted
for majority of the investment funds, and the sum match the theoretical results very
well. That means, China insurance companies think much of investment security. And
we can learn from table 7 that with the return of portfolio increase, the proportion of
enterprise bonds maintained, and the proportions of Treasury bond and stock
increased, whereas the proportion of deposit decreased. Therefore, if China insurance
companies want to obtain a higher investment return, they need to reduce the
investment of bank deposit and enhance the investment of security funds and stocks
under effective risk control.
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Appendix
Table2: Proportion of Investment Asset to Total Asset of China Life Insurance Group
2000-2006
2006 2005 2004 2003 2002 2001 2000 average
Table 6: the Proportion of Investment Asset to Total Asset of PICC Insurance Group
2000-2006
2006 2005 2004 2003 2002 2001 2000 average