Managing Institutional Investor Portfolios

1.

INTRODUCTION

Institutional investors refer to corporations or other legal
entities that serve as financial intermediaries between
individuals and investment markets. These include
pension plans, foundations, endowments, life insurance
2.

companies, non-life insurance companies, and
commercial banks. These entities have diverse
investment objectives and constraints.

PENSION FUNDS

Pension funds are used to support a promise of
retirement income made by an organization, called
plan sponsor.
Types of Pension Funds:
Defined-benefit (DB) plans: The defined-benefit plans are
plans under which the plan sponsor (i.e. employer)
promises to pay plan participants (i.e. retirees) a predefined amount (commonly a % of salary) each month
during retirement.
• These benefit payment promises represent “pension
liability” of sponsor because the risk associated with
funding the benefit obligation is borne by the
employer/plan sponsor.
• The pension liability in DB plans is based on various

assumptions (e.g. number of years of service and
final earnings) and thus it is uncertain and difficult to
estimate.
Defined-contribution (DC) plans: The definedcontribution plans are plans under which the employer
(i.e. plan sponsor) is only required to contribute a
specific amount to the employee’s retirement fund each
year.
• Under DC plans, the pension fund belongs to the
employee (beneficiary), such that, he/she does not
lose the benefit upon changing jobs; the
participants are entitled to receive the value of the
pension account as either a lump-sum or a series of
payments upon withdrawal from the plan or upon
retirement. However, employees are subject to
vesting requirements of 3-5 years i.e. they cannot
withdraw their employer contributions until after they
have been employed with the sponsor for a
specified period of time.
o This portability feature allows participants to
diversify retirement portfolio to suit their needs.
• Any risk (benefit) associated with pension plan assets
is born by the employee.
• In addition, the DC pension plans are tax-deferred
and thus lower taxable income of participants.
• DC pension plans are attractive for employers as
they involve lower liquidity requirements, require
fewer resources to meet contributions and are
subject to fewer regulations.

There are two arrangements in DC plans:

i. Pension plans in which the plan sponsor only promises
the contribution, not the benefit;
ii. Profit-sharing plans in which contributions are based
on profits of the plan sponsor.
Types of DC plans:
Sponsor directed: In a sponsor directed DC plan, the
investments are chosen by the sponsor (like in DB plan).
However, it is less complex than DB plans.
Participant directed: In a participant directed DC plan,
the participants determine their own personalized
investment policy by choosing investments from a menu
of diversified investment options provided by plan
sponsor. Most DC plans are participant directed.
Hybrid plans: Hybrid plans have the characteristics of
both DB and DC plans. It is discussed in detail in section
2.3.
The key differences between DC and DB plans
DB plans

DC plans

1.

A specific future benefit is
promised which has
generated pension liability
for the plan sponsor; no
specific present obligation.

Only present

contribution is
promised; not future
benefit.

2.

Promise is made for the
retirement stage.

Promise is made for
the current stage.

3.

Investment risk is borne by
plan sponsor/employer.

Investment risk is
borne by plan
participants.

4.

Plan participants are
exposed to risk of early
plan termination (e.g. if a
company is liquidated).

Plan participants are
NOT exposed to

early termination risk
because the pension
account legally
belongs to the plan
participants.

5.

DB plans are NOT portable.

DC plans are
portable to plan
participants upon
changing jobs.
However, they are
subject to certain

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FinQuiz Notes 2 0 1 8

Reading 13


Reading 13

Managing Institutional Investor Portfolios

DB plans


DC plans
rules, vesting
schedules, and
possible tax
penalties and
payments.

2.1

Defined-Benefit Plans: Background and
Investment Setting

Three basic liability measures for determining pension
liability are as follows:
1) Accumulated benefit obligation (ABO): The ABO
represents the present value of pension benefits that
are owed to an employee to date(i.e. associated
with accumulated service), whether vested or not.
ABO does not include any future benefits to be
earned by employees.
• It is the most appropriate estimate of total pension
liability for a terminated plan.

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status is > 100%.
• When value of plan’s assets < present value of plan
liabilities
plan is under-funded i.e. plan’s funded
status is < 100%.

• When value of plan’s assets = present value of plan
liabilities
plan is fully-funded i.e. plan’s funded
status is = 100%.
Important to Note: Maintaining funded status of a plan
requires increase in contributions to the plan by the plan
sponsor.
2.1.1) Risk Objectives
The ability of a DB pension plan to tolerate investment
risk is governed by several factors, such as:
A. Plan status:
When pension plan is overfunded (i.e. positive funded
status or plan surplus), the plan sponsor has greater
ability to tolerate risk (all else equal), implying an aboveaverage risk tolerance.
Reason:

2) Projected benefit obligation (PBO): The PBO
represents the present value of all benefits that
employees are expected to earn during employment.
The PBO measure incorporates the impact of
expected future compensation increases.
• It is the most appropriate estimate of total future
pension liability for a going concern companies.
Commonly, the funded status is computed using
PBO.
3) Total future liability: It represents the present value of
accumulated and projected future service benefits
and takes into account the impact of expected
future compensation increases as well as changes in
the workforce and benefit changes associated with

inflation. It is the most comprehensive but also the
most uncertain pension liability measure.
The primary objective of plan assets is to fund future
pension liabilities. The ability of a pension fund to meet its
future liabilities is measured by the funded status of a
plan.
Funded Status of Pension Plan = Market value of Pension
plan assets – Present value of pension plan liabilities
Where,
Present value of pension liabilities is found by discounting
the value of pension liabilities at some discount rate,
typically, the yield of high quality, long-term, investment
grade corporate bonds).
The lower (higher) the discount rate, the greater
(smaller) the present value of pension liabilities.
• When value of plan’s assets > present value of plan
liabilities
plan is over-funded i.e. plan’s funded

• Because plan surplus acts as a cushion and enables
pension fund to tolerate some level of negative
returns without jeopardizing plan’s ability to meet
pension liability payments using plan assets.
• In addition, over-funded pension plan implies lower
costs for the sponsor in terms of lower contributions.
When pension plan is underfunded (i.e. negative funded
status), the plan sponsor has lower ability to tolerate risk
(all else equal),implying under-funded plan has belowaverage risk tolerance.
• It is important to understand that when pension plan
is underfunded, then the plan sponsor may have

higher willingness to take risk in order to generate
higher returns so that the plan can be made fullyfunded.
• An under-funded plan status increases costs of the
sponsor in the form of requirement of greater
contributions to the plan.
B. Sponsor’s financial status and profitability: Sponsor’s
financial status is determined using debt-to-assets
ratio, and profitability is judged through current and
expected profitability of a company.
• When the sponsoring company is financially strong
(i.e. has low debt ratios/low financial leverage) and
has higher current and expected profitability (i.e.
profitable despite operating in a cyclical industry), it
has greater ability to take risk, implying an aboveaverage risk tolerance (all else equal).
Reason: A financially strong and profitable
sponsoring company has greater ability to fund
shortfalls attributed to negative returns by making
additional contributions to the plan.
• When the sponsor is financially weak, (i.e. has high


Reading 13

Managing Institutional Investor Portfolios

debt ratios/high financial leverage) and has lower
current and expected profitability, it has lower ability
to take risk, implying below-average risk tolerance
(all else equal).
C. Common risk exposures between sponsor and

pension fund: From asset/liability management
perspective, the pension plan assets should be highly
correlated with pension plan liabilities BUT minimally
correlated with sponsoring company’s operating
assets.
• When operating results of a sponsoring company are
highly correlated with pension asset returns, higher
operating risk tends to limit the amount of investment
risk assumed by the plan, implying lower risk
tolerance, all else equal.
Reason: High correlation implies that when the
sponsor’s operating results are weak, the pension
asset returns will also be poor; but, due to weak
operating results, the sponsor will be unable to make
additional contributions to support payment of
benefit obligations.
• In contrast when sponsor operational risk is unrelated
with the investment risk, then if a pension portfolio
faces negative returns, the sponsor will be able to
increase contributions to support payment of benefit
obligations.
D. Plan features: A pension plan which has specific plan
features i.e., early retirement options or option to
receive a lump-sum distributions has lower risk
tolerance (all else equal) because such options tend
to shorten the time horizon of pension plan by
reducing the duration of plan liabilities.
E. Workforce characteristics: It includes two things i.e.
a) Age of workforce: A pension plan with younger or
growing workforce has greater risk tolerance

because the younger the workforce, the greater
the duration of plan liabilities, the lower the liquidity
requirements and the longer the time horizon.
b) Proportion of active lives versus proportion of
retired lives: A pension plan with high ratio of
active lives to retired lives has greater risk tolerance
because the greater the proportion of retired lives,
the greater the pension fund’s liquidity
requirements (i.e. greater cash outflows each
month to retirees), the smaller the duration of plan
liabilities and thus the shorter the time horizon.
Summary:

Funded
status
Financial
status

Pension plan has
above-average
risk tolerance

Pension plan has
below-average risk
tolerance

Over-funded

Under-funded


Strong balance
sheet with low
financial leverage

Weak balance
sheet with high
financial leverage

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Pension plan has
above-average
risk tolerance

Pension plan has
below-average risk
tolerance

Profitability

Profitability is not
adversely
affected by
business cycles

Profitability is
adversely affected
by business cycles

Age of

workforce

Younger or
growing
workforce,
implying longer
duration of
pension liabilities

Older workforce or
currently closed to
new participants,
implying shorter
duration of pension
liabilities

% of active
lives
relative to
retired lives

High % of active
lives relative to
retired lives,
implying low
immediate
liquidity needs

High % of retired
lives relative to

active lives,
implying high
immediate liquidity
needs

Plan
features

No early
retirement or
lump-sum
payment option

Early retirement or
lump-sum payment
option

Practice: Example 1,
Volume 2, Reading 13.

Stating a risk objective of DB pension plans: The risk
objective of DB plans can be manifold, such as:
A. Shortfall risk relative to specified funded status: For
example,
• Pension plan wants a funded status of 100% or >
100% or above some regulatory threshold level.
• Pension plan wants to minimize the probability that
funded status falls below 100%; or
• Pension plan wants to minimize the probability that
funded status falls below 100% to be ≤ 10%.

B. Pension surplus volatility (i.e. standard deviation): For
example,
• Pension plan wants the volatility of pension surplus to
be ≤ 6%.
• Pension plan wants to minimize the volatility of
pension surplus (assets relative to liabilities).
IMPORTANT TO NOTE:
The plan surplus has lower volatility when the value of
plan assets is positively correlated with changes in the
value of plan liabilities.
C. Risk related to contributions: For example,


Reading 13

Managing Institutional Investor Portfolios

• Pension plan wants to minimize the year-to-year
volatility of future contribution payments.
• If currently the plan is over-funded and thus no
contributions are being made by the sponsor, the
pension plan may want to minimize the probability
of making any future contributions.
D. Absolute risk: For example, a pension plan may want
to minimize the risk of large losses within any one asset
class, investment type, industry or sector distributions,
maturity date, or geographic location.

Practice: Example 2,
Volume 2, Reading 13.


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Return objective in numerical terms can be stated as
follows:
Minimum Required return for a fully-funded pension plan
= Discount rate used to calculate the PV of plan liabilities
Desired return for a fully-funded pension plan = Discount
rate used to calculate the PV of plan liabilities + Excess
Target return
• The stated return of DB plans may be higher than the
minimum required return in an attempt to minimize
the probability of making future contributions by the
plan sponsor and/or to decrease pension expense
(or increase pension income); however, the high
return requirement must be consistent with plan’s
ability to tolerate risk.

2.1.2) Return Objectives
Like risk objectives, the return objectives of a DB pension
plan can be manifold.
Primary return objective is “To earn sufficient, inflationadjusted returns that adequately meet expected
pension liabilities”.
In addition to the primary return objectives, the DB plans
may have the following objectives.
Return objectives related to both funding of benefit
payments and future pension contributions: To earn
sufficient, inflation-adjusted returns that adequately
meet pension benefit payments and to minimize the
probability of making future contributions to the plan or

to minimize the amount of sponsor’s future contributions
to the plan so that the company can use its cash for
other productive uses.
• Stretch target: A stretch target refers to the objective
of DB plans to make future pension contributions
equal to zero.
Return objectives for a fully funded or over-funded plan:
A fully-funded or over-funded pension plan may have
an objective to maintain the plan’s funded status
(pension surplus) relative to plan liabilities.
Return objectives for an underfunded pension plan: An
underfunded pension plan may have an objective to
earn return equal to the benchmark return i.e. the return
sufficient to meet pension benefit payments.

IMPORTANT TO NOTE:
The greater (lower) the risk tolerance ability of a pension
plan, the more (less) aggressive risk and return objectives
can be adopted.

Practice: Example 3,
Volume 2, Reading 13.

2.1.3) Liquidity Requirement
Pension plan’s liquidity requirement i.e. its Net cash
outflow can be estimated as:
Net cash outflow = Benefit payments – Pension
contributions – Investment income
Example:
Suppose a pension fund has obligation to pay pension

benefits of $100 million per month. It has an asset base of
$10 billion and receives no pension contributions.
Annual liquidity requirement = ($100 million × 12) / 10
billion = 12%
This implies that in order to meet pension benefit
obligations without eroding capital base, the asset base
needs to grow to 10 billion (1.12) = $11.2 billion.
Pension plan’s liquidity requirement depends on various
factors, including:

A comprehensive return objective may be stated as: To
earn sufficient, inflation-adjusted returns that adequately
meet pension benefit payments, minimize the probability
of making future contributions to the plan and generate
pension income (negative pension expense), resulting in
increase in the sponsor’s reported earnings.

Proportion of retired lives relative to active lives: The
greater the number of retired lives relative to active lives,
the greater the liquidity requirement, all else equal; e.g.
a pension plan of a company operating in a declining
industry will have greater proportion of retired lives.

• A well-funded pension plan with pension income
may have the objective of maintaining or increasing
pension income in order to boost profitability.

Size of annual Sponsor’s contributions to the plan relative
to annual benefit payments: The smaller the sponsor’s
contributions relative to benefits payments, the greater

the liquidity requirement, all else equal.


Reading 13

Managing Institutional Investor Portfolios

Age of workforce served by the plan: A plan with young,
growing (older, declining) workforce tends to have
smaller (greater) liquidity requirements.
Early retirement options and/or the option of retirees to
take lump-sum payments: A pension plan with such
options provided to participants tends to have greater
liquidity requirements.
Funded status of a plan: A fully-funded or overfunded
(under-funded) pension plan tends to have low (high)
liquidity needs, all else equal.
Managing high liquidity needs: Higher liquidity needs of
pension fund can be met by:
• Holding a cash reserve or investments in money
market instruments;
• Taking a long position in stock index futures contracts
to gain equity market exposure;
• Taking a long position in bond futures contracts to
gain bond market exposure;

Practice: Example 4,
Volume 2, Reading 13.

2.1.4) Time Horizon

The time horizon of a DB plan is governed by the
following factors:
Going-concern DB plans versus terminated DB plans: A
going-concern DB plan has a long time horizon, all else
equal. By contrast, a DB plan that is expected to
terminate has a short time horizon.
Age of workforce and proportion of active lives: A DB
pension plan with younger workforce and greater
proportion of active lives has a longer time horizon, all
else equal.
Plan open to new entrants: A DB plan that is open to new
entrants tends to have a long time horizon, all else
equal.
The time horizon can be single-stage or multi-stage. For
example, going-concern DB plans have multi-stage time
horizons related to active lives and retired lives portions
of plan participants.
Time horizon for active-lives portion = Average time to
the normal retirement age
Time horizon for retired-lives portion = Average life
expectancy of retired plan beneficiaries

Practice: Example 5,
Volume 2, Reading 13.

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2.1.5) Tax Concerns
Pension funds are either tax-exempt or are taxed at very
favorable tax rates. Hence, there is little or no need for

tax-sheltered income and the investor can focus on total
return. In addition, tax-exempt bonds are not
appropriate investment vehicles for pension plans.
Investment income and realized capital gains are
typically exempt for taxation. However, corporate
contribution and plan termination does involve the tax
issues
Practice: Example 6,
Volume 2, Reading 13.

2.1.6) Legal and Regulatory Factors
All retirement plans are governed by laws and
regulations that attempt to ensure protection for
beneficiaries by specifying standards of care that must
be met by plan sponsors.
• For example, in the U.S., corporate plans and multiemployer plans are governed by the Employee
Retirement Income Security Act of 1974 (ERISA)
whereas the state and local government plans are
governed by state law and regulations.
• ERISA imposes a higher standard of due diligence on
the investment selection process and also legally
obligates that DB plan must be operated for the sole
interests of beneficiaries (plan participants), not the
sponsor.
2.1.7) Unique Circumstances
This section of the IPS documents any circumstances
unique to the DB pension plan and/or any details that
are not covered elsewhere in the IPS. For example,
• A preference for socially responsible funds;
• Investing in companies with high environmental

standards;
• Self-imposed restrictions on investing in certain
sector/industry/companies or certain asset classes
e.g. company with poor labor practices, company
with poor environmental standards, high-risk assets
like equities etc.
• Size of the pension plan e.g. smaller pension plans
have lack of human and financial resources
available to manage plan assets and to perform
complex due diligence needed to investigate the
investment characteristics of alternative investments
(e.g. private equity, hedge funds, and natural
resources).
• Other specific considerations may include:
o Considerably high average employee age relative
to industry average;
o Low active to retire ratio relative to industry
average;
o Funded status of a plan


Reading 13

Managing Institutional Investor Portfolios

Investment policy statement (IPS) of a DB plan and
strategic asset allocation:
• The IPS must be reviewed annually or more
frequently as required by significant changes in:
o Laws or regulations;

o Funded status of the plan;
o Capital market conditions;
• The plan’s strategic asset allocation depends on the
following factors:
o Plan’s time horizon;
o Funded status of the plan;
o Company’s financial strength;
• The level of risk assumed by the plan is largely
determined by the plan’s strategic asset allocation.
IMPORTANT TO NOTE:
The investment objectives of all the institutional investors
are set by its investment committee.

Practice: Example 7,
Volume 2, Reading 13.

2.1.8) Corporate Risk Management and the Investment
of DB Pension Assets
From asset/liability management perspective, pension
investments should be managed relative to pension
liabilities as well as operating investments rather than
any external index benchmarks.
For example, since pension plan liabilities are interest
rate sensitive, ALM approach involves a substantial use
of interest rate sensitive securities (particularly bonds).
Defined-Contribution Plans: Background and
Investment Setting

2.2
NOTE:


In the following section, the investment policy statement
of participant-directed plans is discussed.
2.2.1) The Objectives and Constraints Framework
Roles and Responsibilities of a Plan Sponsor in a DC
retirement plan:
• The plan sponsor is responsible to ensure adequate
diversification by offering a menu of plan investment
options, by limiting holdings in the sponsor’s
company stock and by monitoring the fund
objectives to facilitate participants to invest
according to their varying investment needs.
• The plan sponsor is responsible to provide sufficient
investment information to participants on a regular
basis, basic principles of investing as well as
educational resources (e.g., sophisticated retirement
planning tools like Monte Carlo simulation
techniques) to plan participants to help them in
investment decision-making.

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• The plan sponsor is required to monitor the
investment performance (including fees) of funds
made available to plan participants.
o Each fund’s performance is evaluated by the plan
sponsor by comparing its time-weighted returns
and volatility of returns over at least past five years
or longer than that of appropriate market indexes
and to peer group universes.

• Terminating and replacing funds, selecting,
monitoring and recommending the replacement of
the Trustee/Recordkeeper of the plan when
judicious and appropriateness is also the
responsibility of plan sponsor.
• The plan sponsor must allow plan participants to
transfer funds between investment choices at least
once every 90 days.
• The plan sponsor has a legal obligation to establish a
written IPS which helps the members of the plan in
effectively establishing, monitoring, evaluating, and
revising the investment program established for the
DC plan.
An IPS for a participant-directed DC plan documents
the following:
o A set of governing principles and rules.
o The responsibilities of the plan sponsor, the plan
participants, the fund managers, and plan
trustee/record-keeper selected by the plan
sponsor.
o The procedure of selecting and evaluating a
menu of plan options for meeting the fiduciary
responsibility of ensuring diversification and
ensuring that individual objectives and constraints
can be met.
o The investment strategies and alternatives
available to the group of plan participants with
varying risk and return characteristics and with
sufficient diversification properties.
o Criteria for monitoring and evaluating the

performance of investment managers and
investment vehicles relative to appropriate
investment benchmarks.
o Criteria for selecting, terminating and replacing
manager/fund.
o Effective communication procedures for the fund
managers, the trustee/recordkeeper, the plan
sponsor, and the plan participants.
• It is important to note that Plan sponsor of a DC
pension plan complies with ERISA Section 404 (c)
regulations.
Roles and Responsibilities of Plan participants
(beneficiaries) in a DC retirement plan:
• Each plan participant is individually responsible for
selecting a risk and return objective and constraints
consistent with his/her personal financial
circumstances, goals, and risk tolerance.
• In a participant-directed DC plan, the plan sponsor is
not required to counsel or advise the participants
with regard to selecting and periodically evaluating
investments; rather, it is the responsibility of plan
participants (like individual investors) to decide asset
allocation among investment alternatives, to


Reading 13

Managing Institutional Investor Portfolios

establish their savings and investment strategies and

to reallocate assets among funds as needed,
depending on significant changes in personal
circumstances.

Practice: Example 8, 9 & 11,
Volume 2, Reading 13.

2.3

Hybrid and Other Plans

Hybrid plans have the characteristics of both DB and DC
plans and thus, provide the combined benefits of
traditional defined benefit and defined contribution
plans.
Benefits of DC plans include:
• Portability of assets
• Easy to administer for plan sponsors
• Easy to understand for plan participants
Benefits of DB plans include:
• Guaranteed retirement benefits available to
participants
• Benefit payments linked with years of service
• Benefit payments linked to a percentage of salary
Types of Hybrid retirement plans:
1) Cash balance plans: It is the most common type of
hybrid plan. In a cash balance plan, a certain
percentage of salary of each employee is set aside
by the employer and interest is credited on these
contributions.

• Like DB plans, the investment risk in cash balance
plans is borne by the plan sponsor. In some cash
balance plans, the participants are allowed to
select among fixed-income and equity-based
options that generates investment risk for the
participants.
• Like DC plans, the employees (participants) receive
a personalized statement outlining their individual
ownership, account balance, an annual
contribution credit, and an earnings credit that
facilitates portability to a new plan.
• However, unlike a DC plan, the account balance is
hypothetical because the employee does not have
a separate account.

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Contribution credit = % of pay based on age, salary
and/or length of employment
Earnings credit = % increase in the account balance
• At retirement, the participant has the option to
either receive a lump-sum distribution which can be
rolled into another qualified plan or receive a
lifetime annuity.
• Grandfather clause: Under a “Grandfather” clause,
older workers are allowed to choose between
joining a new cash balance plan and continuing
with an existing traditional DB plan.
2) Employee stock ownership plan (ESOP): It is a form of
DC plans under which the employees invest all or

majority of plan assets in employer’s stock. ESOPs
encourage employee ownership in a company.
• Like DC plans, the contribution credit in ESOPs is
determined as a % of pay.
• The final value of the plan for the employees
depends on the vesting schedule, the level of
contributions, and the change in the per-share value
of the stock.
• These plans are subject to different regulations that
vary among countries. E.g. some ESOPs require
employee contributions, some ESOPs prohibit
employee contributions, some ESOPs are allowed to
sell stock to employees at a discount to market
prices, while others may not, some ESOPs are
required to rely on contributions and are not
permitted to borrow to purchase large amounts of
employer stock.
• The plan participants in ESOPs must pay special
attention to the overall diversification of their
investments because the employees have both
human (by working in a sponsoring company) and
financial capital (by sponsoring company’s stock
holdings) at stake in the company.
Objectives of ESOPs:
• To encourage employee ownership in a company;
• To facilitate liquidation of a large block of company
stock held by an individual or small group of people;
• To avoid a public offering of stock;
• To discourage an unfriendly takeover by increasing
employee ownership in a company;

3) Pension equity plans
4) Target benefit plans
5) Floor plans


Reading 13

Managing Institutional Investor Portfolios

3.

3.1

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FOUNDATIONS AND ENDOWMENTS

Foundations: Background and Investment Setting

Foundations are grant-making institutions funded by gifts
and investment assets.
Four types of foundations:
1) Independent foundations or private/family
foundations: These are independent grant-making
institutions that are established to support social,
educational, charitable, or religious activities.
• Sources of Funds: Independent foundations are
funded by an individual donor, family or group of
individuals to fund philanthropic goals. Most of
private foundations do not receive additional assets

into their funds.
• Decision-making Authority: Donor, members of
donor’s family, or independent trustees.
• Annual Spending Requirement: The minimum
amount that private foundations are required to
spend for charitable purposes is known as “annual
spending requirement”. In a given fiscal year, a
private foundation is required to spend 5% or more
of the average market value of its total asset values
in that year plus expenses associated with
generating investment return i.e.
Minimum annual spending requirement = 5% of the
average market value of its total assets
• These foundations do not engage in fund-raising
campaigns, may not receive any new contributions
from the donor and do not receive any government
support. As a result, most private foundations must
generate their entire grant-making and operating
budget from their investment portfolio.
2) Company-sponsored foundations: It is a private
foundation whose grant-making funds are derived
primarily from the contributions of a corporation
(profit-making companies).
• Source of Funds: Endowment and/or annual
contributions from a profit-making corporation.
• Decision-making Authority: Board of trustees, usually
controlled by the sponsoring corporation’s
executives.
• Annual Spending Requirement: A companysponsored foundation is required to spend annually ≥
5% of 12-month average market value of its total

assets plus expenses associated with generating
investment return.
Minimum annual spending requirement = 5% of the
average market value of its total assets
• Investment focus: Short-term, to fund philanthropic
activities.
• It is subject to the same rules and regulations as
other private foundations.

3) Operating foundations: Operating foundations are
private foundations that use their income to support
their own charitable activities rather than supporting
other charitable organizations e.g. a museum.
• Sources of Funds: Funded by an individual donor,
family or group of individuals. They do not depend
on grants from third parties.
• Decision-making Authority: Independent board of
directors.
• Annual Spending Requirement: An operating
foundation is required to spend 85% of interest and
dividend income to support an institution’s own
programs. In addition, it must spend at least 3.33% of
the average market value of its total assets.
• They are similar to public charities or educational
endowments with respect to distributional
requirements and tax treatment for donors.
4) Community foundations: Community foundations
area type of public charity that makes grants for
social, educations, charitable, or religious purposes in
a specific geographic area, community, or region.

• Sources of Funds: Multiple donors as they are funded
by the public.
• Decision-making Authority: Board of directors.
• Annual Spending Requirement: No spending
requirement.
3.1.1) Risk Objectives
Unlike pension funds who have contractually defined
pension liability (i.e. benefit payments), foundations
have undefined liabilities. As a result, they can have
moderate to higher risk tolerance and may accept
higher year-to-year volatility, depending on spending
rate and time horizon. The above-average risk tolerance
is also implied by their long time horizon reflected by
their aim to exist in perpetuity.
• A higher risk tolerance enables foundations to have
aggressive risk and return objectives and adopt
aggressive asset allocation by focusing more on
equities, illiquid assets, and alternative assets.
• Foundations with shorter time horizon (e.g. due to
being “spent down” over a predefined period of
time and due to constant spending of funds on
charitable programs) tend to have below-average
risk tolerance. Foundations with short time horizon
follows conservative investment policy e.g. with S.D.
of annual returns between 5-7% (intermediate-term
bonds typically fall in this range).
Risk objective may be stated as: “To minimize large
fluctuations/volatility in spending to avoid disruption of
the institution’s budget and finances and to provide a
stable flow of funds”.



Reading 13

Managing Institutional Investor Portfolios

3.1.2) Return Objectives
• When a foundation is a primary or sole source of
funding, then the primary objective of its investment
portfolio will be to provide a stable, reliable flow of
funds to support ongoing operations of the
organization.
• When foundations are intended to operate in
perpetuity (i.e. have infinitely long time horizon), their
long-term return objective is to preserve the real
(inflation-adjusted) value of the investment assets
while maintaining the minimum spending rate
requirement for providing a stable, reliable flow of
funds.
o This total return approach helps to meet
intergenerational equity or neutrality (i.e. equally
treating the interests of current beneficiaries and
future beneficiaries of the foundation’s support) by
both maintaining year-to-year budget stability and
protecting future purchasing power of the fund
against the impact of inflation.

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NOTE:

When a foundation is established to fund independent
programs for only at most few years and it is not the
primary source of funding available to those programs,
then it may have the ability to accept short-term
portfolio volatility while seeking high long-term
investment returns.
3.1.3) Liquidity Requirements
In general, foundations have low liquidity needs due to
their predictable nature of cash outflows.
Foundation’s liquidity requirements = Anticipated cash
needs (captured in a foundation’s minimum spending
rate*) + Unanticipated cash needs (not captured in a
foundation’s minimum spending rate) – Contributions
made to the foundation
* It includes Minimum annual spending rate (including
“overhead” expenses e.g. salaries) + Investment
management expenses

Return objective can be stated as:
“To earn rate of return that is sufficient to meet annual
spending needs, to pay expenses associated with
generating investment returns (e.g. fees of managers,
consultants, custodians etc.) and to keep pace with
inflation”.
In numerical terms, the required rate of return can be
stated as follows:
Minimum return requirement = Minimum annual
spending rate + Investment management expenses (i.e.
cost of generating investment returns) + Expected
inflation rate

Or
Minimum return requirement = [(1 + Minimum annual
spending rate) × (1 + Investment management expenses
(i.e. cost of generating investment returns)) × (1 +
Expected inflation rate)] -1
Where, minimum annual spending rate is the benchmark
rate for foundations.
• In addition, some foundations may have the
objective to earn a rate of return greater than the
return needed to maintain the purchasing power of
assets in an attempt to increase its grant-making
ability over time.
• When a foundation is established to meet some
urgent need (i.e. with limited/short time horizon), it
may have the objective to earn a higher return
consistent with its risk tolerance ability.
The performance of investment portfolio of a foundation
is evaluated (at least annually) by comparing the value
of foundation’s investment assets against the spending
rate + expenses + inflation.

Spending rules (i.e. averaging or smoothing rules) can
be used by Foundations to:
• Dampen the adverse effect of volatility in asset
values on spending distributions;
• Avoid large fluctuations in operating budget;
• Avoid erosion in the portfolio’s real value over time;
In addition, the tax authorities in the U.S. allow carryforwards(which facilitate foundations to avoid penalties
for under-spending in one year by spending more in a
subsequent year) and carry-backs (which allow

foundations to under-spend in a subsequent year in
case of over-spending in prior years).
These carry-forwards and carry-backs facilitate
implementation of smoothing rules as well as enable
foundations to increase grant-making in a single year
without jeopardizing the long-term sustainability of its
investment program.
Cash Reserve: Since the average of total asset values or
the dollar value of its spending for a given fiscal year is
not known to a foundation until the end of that year, a
foundation needs to keep a cash reserve (e.g. 10% or
20% of its annual grant-making and spending budget).
This cash reserve is used to avoid spending all of the
budgeted money before the year is ended and the 12month average of asset values is known with greater
certainty.
Uses of Cash Reserve: Keeping cash reserve allows
foundations to increase grants at the year-end during
“up” market years and avoid overspending in flat or
“down” market years.
3.1.4) Time Horizon
• Most foundations are intended to operate in
perpetuity which implies that they have infinitely


Reading 13

Managing Institutional Investor Portfolios

long time horizon and consequently higher risk
tolerance, all else equal.

• However, all foundations do not aim to exist in
perpetuity and may intend to spend down the
principal over a predefined period of time. As a
result, as time passes, their time horizon shortens,
resulting in decrease in risk tolerance over time.
3.1.5) Tax Concerns
The foundation is tax-exempt under present U.S. law as
long as it meets its minimum (5%) spending requirement.
But, foundation’s unrelated business income is subject to
regular corporate tax rate. An unrelated business
income is the income that is not related to charitable
purposes of a foundation. For example, if the real estate
property is debt financed then income from real estate is
taxed as unrelated business income (however, in
proportion to the fraction of the property’s cost financed
with debt).

% of portfolio that may be invested in any given
security.
• Concentrated stock holdings and selling restrictions
imposed by donor for the purpose of retaining voting
rights. Such selling restrictions impede an institution’s
ability to diversify the risk associated with a
concentrated position.
o Some foundations are allowed to use swap
contracts or other derivative contracts to achieve
diversification and to avoid fluctuations in the asset
value associated with concentrated stock holdings
of a single company.


Practice: Example 12,
Volume 2, Reading 13.

3.2
• A private foundation must pay a 2% excise tax
annually on its net investment income. However, if
the charitable distribution for the year ≥ both 5% and
(Average of the previous 5 years’ payout + 1% of the
net investment income), then excise tax can be
reduced to 1%. This favorable tax treatment is
basically provided to encourage spending on
charitable activities.
NOTE:
Net investment income = (Dividends + Interest income +
Capital gains) –Foundation’s Expenses directly
associated with generation of investment income
(investment management & brokerage fees)
3.1.6) Legal and Regulatory Factors
Foundations may be subject to different legal and
regulatory constraints which vary among countries and
types of foundations. In the U.S., foundations are
governed by Uniform Management of Institutional Funds
Act (UMIFA) and IRS (internal revenue service)
regulations. In addition, all foundations must adhere to
prudent investor rule which means that all investments
must be evaluated from a portfolio perspective rather
than on a stand-alone basis. This implies that a
foundation can invest in high risk investments that have
low correlations with portfolio assets.
3.1.7) Unique Circumstances

This section of the IPS documents any circumstances
unique to the endowment or foundation and/or any
details that are not covered elsewhere in the IPS. For
example,
• A preference for socially responsible funds;
• Investing in companies with high environmental
standards;
• Restrictions on investing in certain companies or
asset classes e.g. gambling or tobacco;
• Investment manager-level constraints i.e. limiting the

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Endowments: Background and Investment Setting

Endowments are long-term, permanent funds
established to provide income for continued support of
a not-for-profit organization i.e. universities and colleges,
museums, hospitals, and other organizations.
• Endowments are funded by individual gifts over
time. Some endowments may expect additional
contributions from donor in the future.
• Endowments are not subject to minimum spending
requirements.
Types of Endowments:
A. True Endowments: A true endowment refers to funds
(i.e. gifts) received from external donors with
permanent restriction that the principal (gift amount)
must be invested and maintained in perpetuity and
cannot be spent; only the spending distributions can

be spent to support programs.
B. Quasi-endowments or Funds functioning as
endowment (FFE): FFE refer to endowments
established by the institution rather than by an
external source with no restrictions on the use of
principal. They are treated as long-term financial
capital. They may be subject to self-imposed
restrictions by the board; however, in extraordinary
circumstances, the board may decide to remove its
self-imposed restriction and spend the FFE because
the monies are not permanently restricted.
Restricted versus Unrestricted Endowment Funds:
Restricted Endowment funds: Restricted Endowment
Funds are funds in which the spending is restricted by the
donor to specified purposes e.g. just to support a
professorship.
Unrestricted Endowment funds: Unrestricted Endowment
Funds are funds in which there are no spending
restrictions and the endowed income can be used for
general purposes of the beneficiary institution.


Reading 13

Managing Institutional Investor Portfolios

An endowment fund has two conflicting goals i.e.
• Short-term goal is to provide a substantial, stable
and sustainable flow of income without frequent,
large fluctuations to support current operations of

the beneficiary institution; and
• Long-term goal is to preserve purchasing power of
endowment assets (i.e. by protecting the real value
of the Endowment over time).

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Examples of Spending Rules:
1) Simple spending rule:
Spending t = Spending rate × Endowment’s Ending
market value t-1
NOTE:
Ending market value t-1 = Beginning market value t
Advantages:

Trade-off between short-term and long-term objectives:
Too much current spending will erode the principal value
of the endowment fund, reducing its ability to support
operations in the future; too little current spending will
benefit future beneficiaries of the endowment fund at
the expense of current beneficiaries.
• Similarly, investing in higher-yielding assets allows the
fund to increase spending distributions but ruins
endowment’s principal value by decreasing its
ability to generate adequate inflation-adjusted longterm returns.
• In addition, large fluctuations in year-to-year
spending can disrupt the endowed institution’s
operating budget, finances and staffing.

• It is simple to implement;

• This rule accounts for volatility in portfolio value;
Disadvantages:
• In this rule, spending entirely depends on market
values;
• This rule can result in significant volatility in the
amount of spending;
2) Rolling three-year average spending rule:
Spending t = Spending rate × Endowment’s Average
market value of the last three fiscal year-ends

To efficiently manage the trade-off between these two
competing objectives, an endowment needs to adopt a
spending rule that strikes a reasonable balance
between current spending distributions and reinvestment
of the remainder to protect the real value of the
Endowment over time.

Spending t = Spending rate × (1/3) [Endowment’s
Ending market value t-1+ Endowment’s Ending market
value t-2 + Endowment’s Ending market value t-3]

Spending Rules: In general,

Drawbacks: It places equal emphasis on market values
three years ago and recent market values. As a result,
highly volatile returns three years ago may cause a
dramatic change in spending in the current year despite
stable returns in the last two years.

Annual amount of Spending = % of an endowment’s

current market value
Or
Annual amount of Spending = % of an endowment’s
average trailing market value
• Spending rule based on average trailing market
value is preferred to use as it provides greater
stability in the annual amount of spending.
Uses of Spending Rule:
• Helps in preserving the long-term objectives of the
endowment;
• Ensures smooth and predictable spending
distributions;
• Protects endowment assets against inflation;
• Dampens the adverse effect of volatility in asset
values on spending distributions and consequently
allowing the endowed institution to accept shortterm portfolio volatility while seeking high long-term
investment returns necessary to fund programs and
to maintain purchasing power.

Advantage: This spending rule provides greater stability
in the annual amount of spending.

3) Geometric smoothing rule: In this rule, annual
spending amount is estimated as % of geometrically
declining average of trailing endowment values
adjusted for inflation i.e.
Spendingt = Weighted average of the prior year’s
spending adjusted for inflation + Spending rate ×
Beginning market value of the prior fiscal year
Spending t = Smoothing rate × [Spending t-1 × (1 +

Inflation t-1)] + (1 – Smoothing rate) × (Spending rate ×
Beginning market value t-1 of the endowment)
It is considered as a more appropriate spending rule
because:
• It places more emphasis on recent market values
and less on past values.
• By incorporating previous year’s beginning spending
rather than ending endowment market value, this
spending rule eliminates large fluctuations in year-toyear spending and aids the beneficiary institution to
plan in advance for its operating budget needs.


Reading 13

Managing Institutional Investor Portfolios

• By adjusting spending levels towards the long-term
target spending level and for the changes in
endowment market value, this spending rule
provides stability in long-term purchasing power.
NOTE:
Interpretation of a 75/25 smoothing rule: 75% of last
year’s spending and 25% of 5% of last year’s endowment
market value.
3.2.1) Risk Objectives
The Risk objectives of an endowment fund can be stated
in the following ways:
• To minimize the risk of dramatic decline in
endowment purchasing power (real value) over a
certain time horizon; or

• To minimize the risk of volatile short-term declines in
asset values or annual spending flows;
• To minimize the risk of substantial decline in support
for the operating budget.
It is important to understand that taking low investment
risk does not necessarily imply low risk of purchasing
power impairment or low risk of not meeting endowment
objectives because low risk investments provide low
expected returns which decrease an endowment’s
ability to provide stable and sustainable flow of funds.
In general, endowments have high risk tolerance (but
lower than that of foundations due to short-term
budgetary needs of beneficiary institution) and thus
higher ability to accept higher volatility in the short-term
to maximize long-term total returns as implied by the
following reasons:
• Long time horizon
• Predictable cash flows relative to spending
requirements
Risk Tolerance of Endowments is governed by the
following factors:
a) Smoothing rule: Endowments that use a smoothing
spending rule tend to have high tolerance for
assuming short-term portfolio risk (i.e. volatile shortterm declines in asset values or annual spending
flows)which increases the endowment’s ability to take
on risk while striving for higher long-term returns
compared to endowments with no spending rule, all
else equal.
b) Relative importance of the Endowment in the
operating budget of the beneficiary institution and

institution’s ability to adapt to drops in spending:
When an endowment’s contributions constitute a
substantial (minimal) portion of the beneficiary
institution’s annual budget, the endowment fund may
have below-average (above-average) risk tolerance
because poor investment returns may have serious
(little) impact on the endowed institution, all else
equal.

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c) Level of debt/ financial leverage and operating
leverage in the Endowed Institution: All else being
equal, when an endowed institution is debt-free
and/or has low operating leverage, it has aboveaverage risk tolerance. In contrast, when an
endowed institution has high financial leverage
and/or high operating leverage, it has belowaverage risk tolerance, all else equal.
d) Common risk exposures between donor and
endowment fund: When both donor and its
endowment fund are affected by same market
forces then during poor market conditions donations
and endowment income will fall at the same time,
which implies below-average risk tolerance for the
endowment fund.
e) Short-term performance of endowment fund: An
endowment with strong (poor) recent performance
tends to have above-average (below-average) risk
tolerance on short-term basis.
• Despite long-term investment objective of
endowment fund, it is important to have high

tolerance for short-term volatility and strong shortterm performance for several reasons i.e.
o Poor recent investment returns may cause a
decline in the level of endowment spending.
o Investment staff and trustees are evaluated on
relatively short-term frames.
o The performance of endowment funds are often
evaluated on an annual basis.
f) Smoothed spending rate relative to target spending
rate: When the smoothed spending rate is less
(greater) than the long-term average or target rate
then, on short-term basis, an endowment’s risk
tolerance can be greater (lower) due to low (high)
risk of a severe loss in purchasing power.
g) Amount and Source of external funding: Endowments
with a more stable or reliable external funding source
(e.g. public donations) tend to have higher risk
tolerance, all else equal. Similarly, the greater the
external funding (donations), the lower the % of
invested assets is required to meet current spending
needs and consequently, the higher the risk
tolerance.
NOTE:
It must be stressed that a high required return objective
and an objective to meet relatively high spending needs
imply a high willingness (not high ability) to accept risk.
For example, increase in expected inflation rate may
make endowment to demand a higher real return to
offset perceived increase in risk, reflecting higher risk
tolerance in the form of higher willingness to take risk.
3.2.2) Return Objectives

The primary objective of endowments is “to maintain or
grow the value (i.e. purchasing power after inflation) of
endowment’s assets in perpetuity” and the secondary
objective is “to achieve investment returns sufficient to
provide substantial, stable, and sustainable flow of
income needed to support ongoing operations”.


Reading 13

Managing Institutional Investor Portfolios

In numerical terms, it can be stated as:
Minimum Required rate of return = Spending rate + Cost
of generating investment returns + Expected inflation
rate
Or
Minimum Required rate of return = [(1 + Spending rate) ×
(1 + Cost of generating investment returns) × (1 +
Expected inflation rate)] -1
To provide a substantial flow of spending distributions to
institutions that are affected by high rates of inflation
compared to the general economy* (e.g. universities
have higher education expenses as it is difficult to
increase faculty productivity without impairing the
quality of education), endowments needs to generate
relatively high long-term rates of return to offset impact
of higher inflation
NOTE:
*Higher Education Price Index (HEPI) is greater than CPI

or GDP deflator by approx 1%.
IMPORTANT TO NOTE:
• When returns are Volatile: In order to preserve
purchasing power in the long-term, an endowment’s
long-term average spending rate must be less than
the long-term expected real rate of return so that
the returns in excess of spending will be reinvested,
thus allowing for real growth of endowment assets.
• When returns are Stable (or not volatile): An
endowment’s spending rate can be equal to the
expected real rate of return.
3.2.3) Liquidity Requirements
Endowment funds have relatively limited liquidity needs
due to their goal to exist in perpetuity and measured
spending.
Liquidity needs = Annual spending needs + Expenses of
generating investment earnings – Contributions by donor
• However, some cash is needed to make spending
distributions, to meet capital commitments, to meet
emergency needs, and for rebalancing transactions.
Such liquidity needs can be met from investment
yield, bond maturation, sale of securities and gifts.
• In addition, Quasi-endowments may need cash for
major capital projects (i.e. for the construction of a
building) which represents higher liquidity
requirements until the capital expenditure is
completed.
In general, due to limited liquidity requirements,
endowments can invest in illiquid, non-marketable
securities.


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3.2.4) Time Horizon
• In general, the endowments have a single-stage,
long-term, indefinite time horizon due to their
objective of maintaining purchasing power in
perpetuity. As a result, they can assume aboveaverage level of return volatility in exchange for
generating higher expected rate of returns over the
longer time horizon.
• However, endowments may have a multi-stage time
horizon due to their short-term liquidity needs i.e. to
provide spending distributions on an annual basis as
well as planned de-capitalizations (reductions in
capital e.g. to fund large projects for quasiendowments).
IMPORTANT TO NOTE:
The endowment funds follow a concept of
“intergenerational equity or neutrality” i.e. treating the
next generation as fairly as the present generation.
Intergenerational equity requires the endowment to
balance its short-term income needs with its long-term
need of preserving the real, inflation-adjusted value of
endowment assets.
• The intergenerational equity exists when endowment
investment portfolio has zero real growth rate which
implies that the inflation-adjusted distribution
received by future beneficiaries = Inflation-adjusted
distribution received by current beneficiaries.
The spending rate that helps to achieve
intergenerational equity is estimated as follows:

Neutrality Spending Rate = Real expected return =
Expected total return – Inflation
3.2.5) Tax Concerns
Endowments are tax-exempt organizations, and in most
circumstances, returns on their investments (e.g. interest,
dividends, capital gains, rents, and royalties) are not
taxed. Hence, taxes are not generally a meaningful
constraint for the endowment fund and therefore, taxexempt securities are not appropriate investment
vehicles.
• However, under certain situations, unrelated
business taxable income from operating businesses
or from assets acquired using borrowed funds may
be subject to tax.
• In addition to that, a portion of dividends from nonU.S. securities may be subject to withholding taxes
that can neither be reclaimed nor credited against
U.S. taxes.
3.2.6) Legal and Regulatory Factors
Generally, endowments are subject to fewer regulations.
However, it is important to consider prudent investor rule,
the legal structure of the fund as well as any state or
federal regulation that might influence the


Reading 13

Managing Institutional Investor Portfolios

management of the investment portfolio of an
endowment.
• Endowments are primarily governed by the Uniform

Management of Institutional Funds Act (UMIFA)
which provides rules regarding how much of an
endowment a charity can spend, for what purpose,
and how the charity should invest the endowment
funds.
• At the federal level, the endowed institutions must
comply with tax and securities laws and reporting
requirements. For example, in order to achieve and
maintain tax-exempt status, an endowed institution is
required to ensure that its net earnings do not
benefit any single, private individual.
• In addition, endowment funds must comply with any
spending restrictions imposed by the donor; and
when an endowment’s market value is less than its
original gift value then it must only spend its income,
not principal.

Practice: Example 13,
Volume 2, Reading 13.

Foundations

Endowments

Timing of
Funding

• Receive funds
at the
initiation of

the
foundation;
• No further
funds are
added to it in
the future.

• Build up over
time by
individual gifts;
• Can fundraise
on an ongoing
basis;
• May expect new
contributions in
the future.

Time Horizon

• Established to
exist in
perpetuity
(long/infinite
time horizon);
• Some are
established
with a plan to
spend down
the principal
over a predefined

period.

Established to exist
in perpetuity
(long/infinite time
horizon) and follow
“intergenerational
equity, implying
long time horizon.

Minimum
annual
spending
requirement

5% of the
average market
value of total
assets.

Not subject to
spending
requirements.

Liquidity
requirements

Higher liquidity
needs due to
minimum

spending
requirement.

Limited liquidity
needs due to
existence in
perpetuity and
measured
spending.

Degree of
support to the
charitable
program

• May be the
primary or
sole source of
funding with
few
alternative
sources of
funding;
• May be one
of the many
sources of
funding;

Besides
endowment funds,

endowed
institution’s
spending needs
can be met by
other revenue
sources e.g. tuition,
grants, fees, etc.

Since endowments are subject to fewer regulations, it is
necessary for the endowed institutions to develop,
maintain, and enforce clear guidelines and policies to
avoid improper behavior and manage conflicts of
interest.
3.2.7) Unique Circumstances
This section documents specific or unique circumstances
of an endowment that dictate the types of potential
investments and investment strategies used by
endowments. For example:
Resources (including staff resources) and size of an
endowment: Endowments need to have substantial
resources and expertise for investing in nontraditional
asset classes or alternative investments which require
complex due diligence and active management.
• In addition, endowments must generally have at
least $25 million of investments to qualify for the
investment in alternative investment funds.
Self-imposed restrictions by the fund trustees or board:
For example, ethical investment policies, socially
responsible investing policies etc.
Other issues not discussed elsewhere in the IPS: These

include
• Type of Industry in which an endowed institution
operates e.g. cyclical or non-cyclical;
• Financial status of endowed institution;
• Operating results of endowed institution;
E.g. endowment fund will have a more conservative
investment strategy if the endowed institution operates
in a cyclical industry, is financially distressed and suffers
from persistent, growing operating deficits.

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Reading 13

Managing Institutional Investor Portfolios

4.

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THE INSURANCE INDUSTRY

By providing financial protection, insurance industry
plays a critical role in the economic growth and
development of a country. Like DB pension funds,
insurance companies have contractual obligations to
policyholders; as a result, they follow conservative
investment strategies.


in their policies at below-market, contractually defined
policy loan rates. Increase in demand for policy loan
leads to reduction in the duration of liabilities;
consequently, insurers need to reduce the average
duration of their portfolios and need to hold greater
liquidity reserves.

Two types of Insurance Companies:

Disintermediation risk: It occurs when during rising
interest rate environment, policyholders withdraw their
funds from a life insurance company and reinvest those
proceeds in other financial intermediaries or investments
offering a higher return (yield). Due to disintermediation,
liabilities of life insurers have become more interest rate
sensitive and the duration of liabilities is shortened,
leading to reduction in average duration of portfolio
and higher demand for liquidity reserves.

1. Life Insurance Companies: Life insurance companies
provide protection against the possibility of death,
illnesses, and retirement.
2. Non-life insurance or Casualty Companies: Non-life
insurance or casualty companies provide health,
property, personal injury, liability, marine, survey, and
workers’ compensation insurance etc.
The insurance industry can be divided into three broad
product categories:
1) Life insurance
2) Health insurance

3) Property and liability insurance
Types of Ownership for Insurance companies (life or
casualty): Insurance companies can be organized in
two different ways i.e.
Stock Companies: A stock company is owned by the
shareholders.
Mutual Companies: A mutual company is owned by
policyholders.
• When a mutual company is converted into a stock
company to gain access to stock market by
distributing its existing capital and reserves to its
policyholders, the process is referred to as
“Demutualization”.
4.1

Life Insurance Companies: Background and
Investment Setting

• For interest-rate sensitive life insurance products,
cash surrender rates are more critical factor than
mortality rates as they are relatively difficult to
predict.
Thus, volatile investment returns in recent years and
competitive pressures have forced insurers to be less
conservative in their interest rate assumptions and to
offer competitive cash value accumulation rates or
credited rates. Consequently, interest rate changes
have a substantial impact on the profitability of life
insurance companies.
2) Term Life Insurance: This policy provides death

benefits for a specified length of time i.e. protection
expires at the end of the policy period, unless
renewed. Unlike ordinary life insurance, it does not
have the benefit of cash values and premiums are
much lower than whole life policies.
To offset disintermediation risk, life insurance companies
has developed the following new products:

Risks associated with high interest rates faced by Insurers
in Ordinary Life Insurance:

a) Universal life: It is a type of ordinary (or whole) life
policy but provides more flexibility than whole life as it
allows the policyholder to shift money between the
insurance and savings component of the policy and
to decide the amount and frequency of payments. In
addition to providing protection against premature
death, it has a saving account component with an
adjustable death benefit, which provides
policyholders an opportunity to save or invest at
variable interest rates i.e. that vary with capital
market and competitive conditions. In universal life
policy, investment risk is borne by the policyholder
instead of the insurance company and the income
on the savings component accumulates on a tax
deferred basis.

Policy loans: During rising interest rate environment,
policyholders of ordinary life policies have the option to
borrow some or all against the accumulated cash value


b) Variable life insurance (unit-linked life insurance): It is
a type of ordinary life insurance where the premiums
are fixed but death benefit and the cash value are

Types of Life Insurance Policies:
1) Ordinary Life Insurance: It is also known as Whole Life
Insurance. This insurance policy provides lifetime
protection by paying fixed death benefits for the
whole of the insured’s life as well as cash value
component that increases with credited rate (i.e. the
interest rate credited to policyholder).
Cash value = Initial premium paid + Any accrued
interest on that premium


Reading 13

Managing Institutional Investor Portfolios

both linked to investment performance of investment
selections made by the policyholder i.e. the better
the performance of investments, the larger the death
benefits and cash values. However, the death benefit
cannot fall below a certain floor value, irrespective of
investment performance. Like universal life policy,
returns are generally not guaranteed and investment
risk is assumed by the policy holder instead of the
insurance company.
Term Insurance


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c) Variable universal life (flexible-premium variable life):
As the name implies, it is a combination of universal
life and variable life policy i.e. it provides the flexibility
of universal life and also allows the policyholder to
select investments for the savings portion of the
account.

Ordinary Life
Insurance

Variable Life
Insurance

Universal Life
Insurance

Variable Universal
Life Insurance

Death benefit
paid

Level or
decreasing death
benefit

Level death

benefit

Guaranteed
minimum death
benefit plus
increased
amount from
favorable
investment returns

Either level or an
increasing death
benefit

Either level or an
increasing death
benefit

Cash value

No cash value

Guaranteed cash
values

Cash value
depends on
investment
performance
(non guaranteed)


Guaranteed
minimum cash
value plus excess
interest credited
to the account

Cash value
depends on
investment
performance (not
guaranteed)

Premiums paid

Premiums
increase at each
renewal

Level premiums

Fixed-level
premiums

Flexible premiums

Flexible premiums

Policy loans


No

Yes

Yes

Yes

Yes

Partial
withdrawal of
cash value

No

No

No

Yes

Yes

Surrender
charge

No

No explicit

charge stated
(reflected in cash
values)

Yes

Yes

Yes

Source: Pearson Addison-Wesley

4.1.1) Risk Objectives
Policy reserves, also called legal reserves, are a major
liability item of the life insurance companies.
Policy reserve = Present value of future benefits - Present
value of future net premiums
Due to the contractual obligations to policyholders
(future liabilities) and greater sensitivity to interest rate
related risk, life insurance companies have a low
tolerance for the risk of loss of principal or the disruptions
in investment income (i.e. uncertain cash flows).
• Due to their nature of liabilities, insurance companies
are considered as “Quasi-trust” funds.
• To manage the risk of meeting insurance liabilities,
investment portfolio is invested in low-risk assets of
similar durations and surplus funds are invested in
riskier securities. Surplus is a key indicator of financial
strength of an insurance company and helps to
support expansion of business volume.


Surplus = Total assets of an insurance company - Total
liabilities of an insurance company
For mutual insurance company
Policyholders’ surplus
For stock insurance company
equity for a stock company

Surplus =

Surplus = Stockholder’s

Risk objectives can be stated as “To minimize the risk of
insolvency and inability to meet policyholder claims and
risk of principal loss by maintaining sufficient cash
reserves and surplus relative to liabilities and by
efficiently managing interest rate risk”.
Asset Valuation Reserve (AVR): The National Association
for Insurance Commissioners (NAIC), which is the
national regulator in the U.S., requires life insurance
companies to maintain a cushion to guard against
substantial losses. This cushion is known as Asset
Valuation Reserve (AVR).


Reading 13

Managing Institutional Investor Portfolios

• The size of the appropriate AVR depends on the risk

characteristics of their investments e.g. bonds,
preferred stocks and real estate may be carried at
amortized cost, while common stocks may be
carried at market value. In addition, the maximum
amount of reserve may vary by the class of assets.
• When size of AVR is insufficient to absorb significant
losses, the losses in excess of asset valuation reserve
are charged against the surplus (i.e. surplus is written
down/reduced).
Some life insurance companies are also subject to riskbased capital (RBC) requirements i.e. to maintain
adequate surplus to mitigate risk exposures associated
with both assets and liabilities.
Due to the distinct features of life insurance and annuity
contracts, most life insurance companies construct their
portfolios by segmenting them in a way such that the
most appropriate securities (i.e. with interest-rate
sensitivity similar to that of product/liability segment)
fund each product segment. The risk tolerance of a life
insurance company may vary by portfolio segments e.g.
minimum return segment has lower risk tolerance while
the surplus segment has greater risk tolerance.
Life insurance companies are exposed to interest-raterelated risk because their liabilities (e.g. annuity
contracts) are interest rate sensitive. Life insurance
companies are exposed to the following two types of
interest rate risks:
1. Valuation concerns: It refers to a decline in the value
of surplus resulting from changes in interest rates due
to mismatch between the duration of an insurance
company’s assets and duration of an insurance
company’s liabilities. For example,

• If average duration of assets > average duration of
liabilities, then during periods of rising interest rates
fall in the value of assets will be greater than that of
liabilities
leading to losses and reduction in surplus.
This implies that when average duration of assets >
average duration of liabilities, then an insurer has low
risk tolerance due to valuation concerns.
• Similarly, If average duration of assets < average
duration of liabilities, then during periods of declining
interest rates
increase in the value of assets will be
smaller than that of liabilities
leading to losses and
reduction in surplus.
• The impact of disintermediation risk is also greater
during high interest rates when there is a mismatch
between asset/liability duration.
2. Reinvestment risk: Reinvestment risk is the risk of
reinvesting cash from an interest payment or principal
at a lower interest rate than that of previous
investment. This risk is particularly greater in annuity
and guaranteed investment contracts with fixed
credited rates. During declining interest rates,
insurance companies offering such contracts face
the difficulty to earn their required return in order to

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earn positive interest rate spread above that of the

required return.
Other risks include:
Credit risk: It refers to the risk of default of securities held
by the life insurance companies in their investment
portfolio. This risk is managed by careful and intensive
credit analysis, by broadly diversifying the investments
within the portfolio and/or by demanding higher
expected return or interest rate spread for investing in
high credit risk investments.
Cash flow volatility: It refers to the risk of uncertainty and
volatility in the timing of receipt of cash flows, e.g. loss of
income or delays in collecting and reinvesting cash flow
investments.
In summary, key risk objectives include:
• To minimize interest rate sensitivity i.e.
o To control valuation concern risk by targeting
portfolio duration to match liabilities’ duration;
o To manage disintermediation risk;
o To control reinvestment risk;
• To manage credit risk by achieving portfolio
diversification, both at a sector and issuer level;
• To manage cash flow volatility risk by maintaining
sufficient short term cash and liquidity to fund
immediate and short-term liabilities;
While insurance companies are required to control risk,
many companies are forced to mismatch asset/liability
durations or downgrade the credit quality of their
investments in an attempt to achieve higher returns for
competitive reasons.
4.1.2) Return Objectives

The primary return objective of life insurance companies
is to earn a certain minimum required return on their
investments to fund future policyholder benefit claims.
Any return in excess of the minimum required return
represents profit for the life insurance company.
The return objective of a life insurance company can be
threefold:
1) To earn a minimum required return, sufficient to meet
future policyholder benefit claims. In numerical terms,
it can be stated as:
Minimum required rate of return = Credited rates
• This objective can be best met by investing in
safe/low-risk and high income securities (e.g. fixed
income and preferred stocks).
2) To earn a positive net interest rate spread (i.e. interest
earned on its assets - interest paid to policyholders) in
order to generate additional profits and/or to achieve
competitive advantage by setting lower insurance
premiums. In numerical terms, it can be stated as:


Reading 13

Managing Institutional Investor Portfolios

Required rate of return = Credited rates + Excess Target
rate
3) To achieve surplus growth in an attempt to support
expanding business volume and to achieve
competitive advantage by setting lower insurance

premiums;
• Return objectives of earning positive net interest
spread and growing surplus capital can be best met
by investing in high risk, high return securities and
securities with greater capital appreciation (e.g.
common stocks, equity investments in real estate,
and private equity etc.).
Like risk tolerance, the return objectives vary by portfolio
segments e.g. minimum return segment has less
aggressive return objectives while the surplus segment
has aggressive return objectives.
4.1.3) Liquidity Requirements
Liquidity requirements include cash needed to pay
death benefit payments, to meet demand for policy
loans, to meet working capital needs etc. Life insurance
companies have low liquidity needs due to the following
reasons:
i. Cash flows from customer premiums are usually more
than sufficient to meet these liquidity needs;
ii. Growth in the volume of business;
iii. Longer-term nature of liabilities;
iv. Rollover in portfolio assets from maturing securities
and other forms of principal payments;
Due to low liquidity requirements, life insurance
companies can invest in long-term, non-marketable
investments (e.g. real estate, private placements).
• However, uncertain timing of cash needs due to
potential for policy loans or disintermediation during
rising interest rate environments contributes to the
increased liquidity needs. Hence, to avoid incurring

losses on the sale of less marketable (illiquid)
investments to meet liquidity needs, the life
companies must properly assess their liquidity
requirements and invest in less liquid investments so
long as liquidity requirements are not compromised.
• Asset marketability risk: Due to volatile interest rates
and consequently, uncertain timing of cash needs,
life insurance companies are not allowed to invest a
greater portion of their portfolio in less marketable,
illiquid asset classes.
The liquidity requirements and its related risk can be
managed by:
• Using derivative contracts
• Maintaining lines of credit with banks

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4.1.4) Time Horizon
Traditionally, life insurance companies are considered as
long-term investors with investment holding periods
between 20 to 40 years. Hence, they tend to invest in
long-term maturities for bond and mortgage investments
(for matching liabilities’ durations) and in real estate,
common stocks, convertible securities, and venture
capital (to earn higher returns i.e. capital appreciation
and protection against inflation risk).
Other factors that affect duration of liability and in turn
the time horizon of a life insurance company include:
Policy surrenders (disintermediation) and/or loans:
During periods of rising interest rates, disintermediation

and/or policy loans tend to reduce the duration of
liabilities and consequently shorten the time horizon.
Duration of insurance products offered by the company:
For example, a two-year guaranteed investment
contract will have shorter duration, contributing to a
decline in the duration of liabilities and shortening of
time horizon. Similarly, group annuities tend to have
shorter time horizon.
In general terms, time horizons have simply become
shorter due to use of asset/liability management
practices e.g. minimum return segment has a shorter
time horizon while the surplus segment has a longer time
horizon.
4.1.5) Tax Concerns
Unlike pension funds and endowments, insurance
companies are taxable entities; hence, they need to
focus on maximization of their after-tax returns by
selecting the mix of investments that provide the most
favorable after-tax returns.
For tax purposes, the investment income of life insurance
companies can be divided into two categories:
1)

2)

Policyholder’s share i.e. accumulated cash values
that are based on the credited rate (minimum return
determined by actuary): It is tax-deferred investment
for the policyholder.
Corporate share i.e. company’s excess returns or

surplus capital: It is taxed as ordinary income.

The insurance companies are vulnerable to likely
changes in the tax code; hence, portfolio managers
face uncertainty with regard to tax implications of
various portfolio strategies.
4.1.6) Legal and Regulatory Factors
In most countries, insurance companies are subject to
heavy regulations and they must comply with all the
regulations of the state in which they are domiciled.
These regulations have substantial impact on both the
risk and return of portfolio of life insurance companies
because they limit the universe of eligible investments,
asset allocation, and operating flexibility of insurance
companies.


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Managing Institutional Investor Portfolios

Non-life Insurance
Companies

• In the U.S., the life insurance companies are subject
to state rather than federal regulations.
Important concepts related to regulatory and legal
considerations include:
• Eligible investments: The universe of eligible
investments and quality standards for each asset

class are determined by the regulations e.g. in the
U.S., insurance companies can invest ≤ 20% of total
assets in common stocks.
• Prudent investor rule: According to prudent investor
rule, life insurance companies are required to
prudently analyze investment choices consistent with
their investment objectives and constraints rather
than only investing in investments approved under
traditional “laundry lists”.
• Valuation methods: In the U.S., for the purpose of
valuation of their portfolio securities, insurance
companies are required to use the values or
valuation bases compiled by NAIC’s Security
Valuation Book. This book contains the valuation
data listed in Schedule D (a list of inventory of all
bond and stock holdings at year-end and a recap
of the year’s transactions).

line.

Non-Life Insurance Companies: Background and
Investment Setting

Fairly quick
compared to
Non-life
companies

Risk exposures


• Most (not all)
nonlife
companies are
exposed to
inflation risk
because they
offer
replacement
cost coverage.
• They are not
exposed to
interest rate risk
because their
policies do not
typically pay
returns on a
periodic basis.

Directly
exposed to
interest rate risk

Value of
liabilities

Uncertain

Certain

Timing of

liabilities

Uncertain

Uncertain

Operating
results

Relatively more
volatile operating
results due to
highly uncertain
liabilities

Relatively less
volatile
operating results
due to certain
value of
liabilities

Investment
returns

Vary significantly
from company to
company due to:
• Differences in
regulations

• Differences in
product mix and
liabilities
duration
• Differences in
tax position
• Differences in
preference with

Almost identical
among
companies

Like life insurance companies, casualty insurance
companies are considered as quasi-trust funds.
Differences between Non-life Insurance and Life
Insurance Companies

Customers or
buyers of
insurance
policies
Duration of
Liabilities

Non-life Insurance
Companies

Life Insurance
Companies


Commercial
customers

Individuals

Relatively Shortterm liabilities
Liability duration
vary by product

Relatively Longterm liabilities
Liability duration
vary by product

line.

Longer than life
companies i.e.
long time span
(months and years)
between the date
of the occurrence
and reporting of
the claim and the
actual payment of
a settlement to a
policyholder.
Hence, the nature
of liability of nonlife companies is
referred to as

“Long-tail”.

Insurance companies (whether life or non-life) may have
unique circumstances that dictate the types of potential
investments and investment strategies used by them.
These may include:

4.2

Life Insurance
Companies

Insurance
Claim
processing
and payments
periods

4.1.7) Unique Circumstances

• Size of the insurance company;
• Sufficiency of surplus capital of an insurance
company;
• Diversity of product offerings of an insurance
company;
• Strength of the balance sheet of an insurance
company;

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Reading 13

Managing Institutional Investor Portfolios

Non-life Insurance
Companies

Life Insurance
Companies

regard to
capital
appreciation
versus the
income
component
• Differences in
capital and
surplus positions
Liquidity
needs

Depend on
business cycles
and underwriting
cycles

Depend on
interest rate

cycles

Earnings of non-life insurance companies consist of
underwriting profitability plus investment income.
Underwriting profits = Premiums earned during the period
-Incurred losses - Loss adjustment expenses - Other
underwriting expenses
Investment income is a source of financial stability to the
company because it helps to offset substantially large
underwriting losses that occur periodically, e.g. due to
natural disasters. Investment income also contributes to
the growth of the surplus that enables the company to
expand its underwriting business volume because more
underwriting business can be done when capital
increases.
4.2.1) Risk Objectives
Non-life insurance companies have highly uncertain and
unpredictable policy liabilities as the timing and values
of cash outflows associated with potential claims are
highly uncertain in nature. Since sufficient funds are
needed to cover unpredictable liabilities, non-life
companies have very low tolerance for the risk of
principal loss. Property/casualty companies also have
lower risk tolerance due to their sensitivity to inflation i.e.
when inflation rate rises, liabilities increase.
In setting risk objectives, the casualty companies must
consider the following factors:
A. Cash flow Characteristics: Due to the uncertain timing
and values of cash outflows associated with potential
claims, non-life companies need to have higher

safety of principal and sufficient investment income to
meet extraordinary large underwriting losses. In
general,
• The portion of investment portfolio related to
policyholder reserves has a low tolerance for risk of
principal loss or disruptions in investment income
whereas the surplus capital portion may have
greater tolerance for risk of principal loss or
disruptions in investment income.
• Regulators and rating agencies closely monitor the
ratio of a casuality insurance company’s premium

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income-to-its total surplus.The casualty companies
are generally required to maintain this ratio between
2-to-1 and 3-to-1.
B. Common stock to surplus ratio: The potential impact
of bear (declining) equity markets on the surplus
capital can be measured by examining proportion of
assets (total surplus) represented by common stocks
i.e. the larger the proportion of common stock
holdings, the greater the erosion of surplus during
declining equity markets and consequently, the lower
the ability to provide sufficient financial stability,
leading to lower risk tolerance for the portion of the
investment portfolio related to surplus.
• Unlike life insurance companies, the non-life
companies have no restrictions with regard to
common stocks as a % of surplus.

4.2.2) Return Objectives
Like life insurance companies, non-life companies divide
their investment assets into two parts i.e.
a) Core holdings or fixed-income segment: They are
held to meet the potential claims of policyholders.
Since non-life companies are not required to meet a
minimum return requirement, core holdings constitute
a smaller portion of assets for non-life companies.
• The return objective for the core holdings portion is
to maximize the fixed-income return in order to meet
liabilities (claims). It may be considered as a shortterm goal.
b) Surplus capital segment: It is invested in common
stocks, convertible securities, and alternative
investments to achieve growth of surplus.
• The return objective for surplus portion is to generate
greater capital appreciation to enable the
company to adopt competitive pricing on policy
premiums and to expand business volume. It may be
considered as a long-term goal.
The return objectives of Non-life insurance companies
vary depending on the following factors:
A. Competitive Policy Pricing: In order to support the
competitive pricing on policy premiums of all
products, the company seeks to earn a high
expected return on its investment portfolio.
• However, it is not advisable to only rely on
investment returns to cover underwriting losses
because the financial stability of a company also
depends on its underwriting quality and profitable
pricing.

• In addition, the return objectives should be
consistent with capital market assumptions and the
insurance company’s ability to accept risk.


Reading 13

Managing Institutional Investor Portfolios

B. Profitability: Unlike life insurance companies, the
minimum required return of non-life insurance
companies does not reflect the credit rate for their
policies; rather, they seek “to maximize the return on
capital and surplus (consistent with asset/liability
management, surplus adequacy considerations, and
management preferences) in an attempt to enhance
profitability; maintain liquidity; and to smooth the
earnings volatility of the typical underwriting cycle”.
The underwriting profitability of the insurance company
can be measured using “combined ratio” which is
estimated as:
Combined Ratio = (Total amount of claims paid out +
Insurer's operating costs) / Premium income
• When the combined ratio is > 100%, it means that for
every premium dollar received, more than a dollar
was spent on losses and expenses.
• The lower the combined ratio is (i.e. < 100%) the
more profitable the insurer.
The return objective related to profitability may also be
stated as “to generate a high level of income to

supplement or offset insurance underwriting gains and
losses (i.e. claims – premium income)”.
C. Growth of Surplus: The insurance company may seek
to contribute to the growth of surplus through capital
appreciation that enables the company to expand its
underwriting business volume. In order to grow capital
surplus, it must be invested in equities and other assets
with greater capital appreciation.
D. Tax considerations: Most non-life insurance
companies prefer to maintain some balance of
taxable and tax-exempt bonds in their portfolios in
order to maximize their after-tax returns.
E. Total return management: Most non-life insurance
companies have adopted active bond portfolio
management strategies in order to maximize total
return on their investment portfolios.
4.2.3) Liquidity Requirements
Non-life insurance companies have high liquidity
requirements compared to life insurance companies
due to the following reasons:
1) Unpredictable cash outflows;
2) Need to shift the portfolio mix between taxable and
tax-exempt bonds depending on the underwriting
performance i.e. during periods of underwriting profits
(loss), a portion of bond portfolio is liquidated to
increase tax-exempt (taxable) income.
3) Shorter time horizon;
4) Underwriting and business cycles: Unlike life insurance
companies, the liquidity needs of non-life companies
are determined through business cycles not interest

rate cycles. Underwriting or profitability cycle
(averaging 3-5 years, in general) follows general
business cycle i.e. premium rates rise faster than claim
costs in the up phase of the cycle (economic
expansion), leading to higher earnings and greater

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capital accumulation; consequently, the premium
rates are lowered to expand business volume.
Afterwards, during the down phase of the cycle
(economic recession), claim costs rise faster than
premium rates.
• The liquidity requirements are particularly high at the
end of the underwriting cycle when claims are most
likely to be paid.
Due to high liqudity needs, non-life insurance
companies, typically,
• Hold an immediate liquidity reserve of short-term
securities i.e. commercial paper or Treasury bills);
• Invest in high-quality, readily marketable
government bonds of various maturities;
• Maintain a balanced or laddered maturity schedule
to ensure sufficient liquidity;
• Match duration of assets with liabilities associated
with seasonal cash flow needs;
• Do not invest in highly illiquid investments;
4.2.4) Time Horizon
Casualty insurance companies have short-time horizons
as implied by two factors i.e.

1) The short time frame of the underwriting cycle that
impacts the portfolio mix of taxable and tax-exempt
bond holdings.
2) Shorter durations of casualty liabilities.
• Casualty companies may invest in longer maturity
bonds to earn higher yields offered on those
securities.
• The investment strategy for surplus capital segment
of the company focuses on achieving long-term
growth and thus implies longer time horizon.
4.2.5) Tax Concerns
• Tax considerations are a very important factor in
determining casualty insurance companies’
investment policy and the optimal asset allocation
because unlike life insurance companies, all
invested assets of non-life insurance companies are
taxable.
o During periods of underwriting profits, the non-life
companies should invest in tax-exempt bonds,
preferred stocks and common stocks in high-tax
regimes in order to achieve some tax-shelter.
o By contrast, during periods of underwriting losses,
non-life companies should invest in taxable bonds.
• The insurance companies are vulnerable to the likely
changes in tax code, which ultimately increases
uncertainty for portfolio managers with regard to tax
implications of various portfolio strategies.

4.2.6) Legal and Regulatory Factors



Reading 13

Managing Institutional Investor Portfolios

The non-life insurance companies are subject to few
regulations compared to life insurance companies as
they are not required to maintain an asset valuation
reserve and have no restrictions related to the choice of
investment assets and the amount of portfolio invested
in any particular asset class. However,
• They are subject to risk-based capital requirements
i.e. they need to maintain minimum capital
requirements depending on the size and degree of
various risks that can be assumed by the insurer.
These risks include:
o Asset risk (risk related to fluctuations in market
value);
o Credit risk
o Underwriting risk (risk related to underestimating
liabilities from business already written or
improperly pricing current or prospective business);
o Off-balance sheet risk (risk related to items not
recorded on the balance sheet);
• They are required to keep assets equal to 50% of
unearned premium.
• They are required to maintain combined loss
reserves in eligible bonds and mortgages.
5.


5.1

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• Casualty insurance companies are required to
maintain premium-to-surplus ratio between 2-to-1
and 3-to-1.
Unique Circumstances:
• The primary unique circumstance that affects a nonlife insurance company is the financial strength of a
company i.e. financially weak companies need to
be more conservative in their investment process.
• Most non-life insurance companies have selfimposed restrictions on the types of investment
assets (e.g. are not allowed to invest in private
placement bonds, commercial mortgage loans, and
real estate due to liquidity concerns) and the
amount that can be invested in specific asset
classes (e.g. common stocks at market value must
represent one-half to three-quarter of the total
surplus).

BANKS AND OTHER INSTITUTIONAL INVESTORS

Banks: Background and Investment Setting

Banks are financial intermediaries who are in the
business of taking deposits and making loans.
Liabilities of a bank include:
a) Deposits e.g. time deposits (in which depositor cannot
withdraw funds without advance notice) and
demand deposits (in which the depositor can

withdraw funds without prior notice i.e. checking
account). Deposits are the major liabilities of banks.
b) Purchased funds;
c) Publicly traded debt;
Assets of a bank include:
a) Loans including real estate, commercial, individual,
and agricultural loan;
b) Portfolio of investment securities;
c) Other assets i.e. trading accounts, bank premises and
fixed assets, other real estate owned, cash and
federal funds;
The chief financial variables that affect bank profitability
include sources of income and expenses.
Banks’ sources of Income include:
• Interest revenues from loans. It depends on the
quantity, duration and credit quality of loans.
• Interest income on investment securities of portfolios.
It depends on the quantity, duration and credit
quality of securities.

• Fees and other non-interest sources of income;
Banks’ expenses include:
• Interest costs on deposits;
• Non-interest expenses;
The profitability measures of a Bank include:
1) Net interest margin: It measures the net interest
income earned by the bank on its income-producing
assets. It is estimated as:
Net interest margin =


(ூ௡௧௘௥௘௦௧ூ௡௖௢௠௘ିூ௡௧௘௥௘௦௧ா௫௣௘௡௦௘)

஺௩௘௥௔௚௘ா௔௥௡௜௡௚஺௦௦௘௧௦
ே௘௧ூ௡௧௘௥௘௦௧ூ௡௖௢௠௘

=

஺௩௘௥௔௚௘ா௔௥௡௜௡௚஺௦௦௘௧௦

• Income-producing or earning assets include loans
and bonds. They do not include discount instruments
i.e. acceptances.
• The higher the net interest margin, the more
profitable the bank will be and the greater the
bank’s ability to profitably manage interest rate risk.


Reading 13

Managing Institutional Investor Portfolios

2) Interest spread: It measures the bank’s ability to invest
in assets with high interest income and to raise
deposits (liabilities) with low interest costs. It is
estimated as:
Interest spread = Average yield on earning assets –
Average percent cost of interestbearing liabilities
• The higher the interest spread, the more profitable
the bank will be and the greater the bank’s ability to
profitably manage interest rate risk.

The risk measures of a Bank include:
1) Leverage-adjusted Duration Gap (LADG): It is used to
measure a bank’s overall sensitivity to changes in
interest rates.
Leverage-adjusted duration gap = DA – (k ×DL)
Where,
DA = Duration of assets
DL = Duration of liabilities
k= Market value of liabilities / Market value of assets =
L/A
Impact of interest rate risk on market value of net worth
of a bank:
Change in market value of net worth of a bank (resulting
from interest rate shock) ≈ - LADG × Size of bank × Size of
interest rate shock
Where,
• Market value of net worth represents the value of
equity claims on the bank.
• LADG = Leverage-adjusted duration gap. The larger
the gap, the greater the exposure of bank to
changes in interest rates.
• Size of bank is measured by assets. The larger the size
of bank, the greater the exposure of bank to
changes in interest rates.
• Size of interest rate shock = Change in interest rate /
(1 + Interest rate). The larger the size of interest rate
shock, the greater the exposure of bank to changes
in interest rates.
IMPORTANT TO NOTE:
Both LADG and size of bank is under the control of a

bank while the interest rate shock is not under the
control of a bank.
For a bank with Positive LADG
positive (negative)
interest rate shock i.e. unexpected increase (decrease)
in rates results in decline (increase) in the market value
of net worth.
For a bank with Negative LADG
positive (negative)
interest rate shock i.e. unexpected increase (decrease)

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in rates results in increase (decrease) in the market value
of net worth.
For a bank with Zero LADG (i.e. an immunized balance
sheet)
positive or negative interest rate shock will
have no effect on the market value of net worth.
2) Position and aggregate Value at Risk (VAR): Value at
Risk (VAR) reflects the minimum amount of potential
loss expected to incur over a given time period (say 1
day, 1 week, quarter, year) with a given level of
probability (say 5% or 1%). E.g. VAR of $100 million on
an asset at a one-week with 95% confidence level
means that there is only a 5% probability that the
value of the asset will decline more than $100 million
over any given week.
3) Credit measures of risk: These may include both
internally developed credit risk measures and

commercially available credit risk measures i.e. Credit
Metrics.
Role and Objectives of Securities Portfolio of a Bank: The
securities portfolio of a bank plays a critical role in
managing a bank’s risk and liquidity positions relative to
its liabilities and in meeting its financial performance
objectives. The important objectives of bank’s securities
portfolio include the following in descending order of
importance:
a) To manage overall interest rate risk of the balance
sheet: Banks tend to hold negotiable and highly liquid
and marketable securities in their investment portfolio
in order to manage and control overall interest rate
risk of the balance sheet. For example, when duration
of bank’s equity is higher than desired, then it can be
shortened by reducing the maturity of securities
portfolio by investing in short duration securities.
b) To manage liquidity: Banks tend to hold negotiable
and highly liquid and marketable securities in their
investment portfolio to ensure availability of adequate
cash to meet liquidity needs.
c) To produce income: Banks hold securities portfolios to
generate higher income in an attempt to enhance
profitability. Excess or residual cash resulting from
deposits that have not been loaned out or from low
demand for loan are invested in high-earning
investment assets.
d) To manage credit risk: Securities portfolio is used to
diversify risk associated with geographically
concentrated or risk-factor concentrated loans of a

bank. E.g. a bank invests in high credit-quality (i.e. low
credit risk) securities to manage and diversify its
overall credit risk exposure to some desired level.
e) To meet pledging requirement: Banks are required to
hold (pledge collateral) government securities
against the uninsured portion of deposits.
From asset/liability management perspective, banks
primarily hold fixed-income securities in their investment
portfolio because both assets (loans) and liabilities
(deposits) are interest-rate sensitive.


Reading 13

Managing Institutional Investor Portfolios

Investment securities (in order of their proportion) in the
balance sheet of a Typical Bank include:
•
•
•
•
•

U.S. government agency and corporate securities
Other domestic debt securities
Municipal securities
U.S. Treasury securities and Non-U.S. debt securities
Equities


NOTE:
Banks also use off-balance sheet derivatives to manage
interest rate and credit risk.
5.1.1) Risk Objectives
Banks tend to have below-average risk tolerance for
interest rate, credit, and liquidity risk in its securities
portfolio because of their critical need to be able to
meet its liabilities to depositors and other entities when
they come due, commonly at short notice.
The primary risk objective of banks is to minimize the risk
of loss of principal and the risk of inadequate liquidity
that may impair a bank’s ability to fund its liabilities to
depositors (withdrawals) and other entities.
Risk objective related to credit risk: To minimize the risk of
loss from defaults of an individual issuer/borrower. To
meet this risk objective, banks seek to diversify risk
associated with geographically concentrated or riskfactor concentrated loans by assuming less credit risk in
their securities portfolio.
Risk objective related to interest rate risk: Typically, the
liabilities of banks (deposits) are short-term in nature
while assets (loans e.g. mortgages) are long-term in
nature. Hence, another important risk objective of banks
is to minimize the interest rate risk exposures of market
value of net worth by managing a mismatch between
the duration of assets and liabilities.
5.1.2) Return Objectives
Generally, a bank’s return objective for its securities
portfolio is to maximize portfolio return over the long term
in a manner that is consistent with liquidity needs,
pledging requirements, asset/liability management

strategies and safety of principal”.
The return objective of a Bank can be divided into one of
the three categories:
1) To earn or maintain positive interest rate spread (and
net interest rate margin) between the asset in which it
invests and the cost of its funds. Positive interest rate
spread facilitates a bank to meet its operating
expenses and earn a fair profit on its capital.
2) To maintain substantial liquidity to meet its
withdrawals (net deposit outflows), loan demand, or
other emergency needs.
3) To maximize return earned on the excess or residual
cash holdings due to net deposit inflows or low loan
demand in an attempt to enhance profitability.
5.1.3) Liquidity Requirements

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Banks have substantial liquidity requirements with regard
to meeting net deposit withdrawals, to meet loan
demands and to meet regulatory requirements.
5.1.4) Time Horizon
The time horizon of banks tends to be short to
intermediate-term in nature (typically between 3-to-7
years) as implied by the following reasons:
• Short-term liquidity needs to meet withdrawal
demand of depositors.
• Focus on short-term investments to avoid interest
rate risk in order to maintain adequate interest rate
spread.

• Shorter maturity of liabilities (deposits) compared to
maturity of loan portfolio, which demands
investment in short-term investments to match the
duration of assets and liabilities.
It must be stressed that short to intermediate term time
horizon also implies below-average risk tolerance for
banks.
5.1.5) Tax Concerns
Banks’ securities portfolios are fully taxable. As a result,
banks need to evaluate performance of taxable and
tax-exempt investments on an after-tax basis to
maximize their after-tax returns.
5.1.6) Legal and Regulatory Factors
Banks are heavily regulated and are required to comply
with all the state and federal banking regulations. These
regulations include:
Restrictions on the amounts that can be invested in
equities or non-investment grade bonds.
Legal reserve and pledging requirements: Under
pledging requirements, banks are required to pledge
collateral (short-term government securities) against
certain uninsured public deposits.
Risk-based Capital (RBC) requirements: The RBC
requirements seek to limit the risk-taking activity of banks
by setting the amount of required capital as a % of both
on and off balance sheet assets of banks. E.g. ratio of
total capital to risk weighted assets must be at least 8%.
• When an asset has a risk weight of 100%, the capital
charge on it is 8%
• When an asset has a risk weight of 50%, the capital

charge on it is 4%
Restrictions on engaging in short sales
Restrictions on hiding investment loss by using adjusting
trade i.e. banks are not allowed to hide an investment
loss by selling a security at a fictitiously high price to a
dealer and simultaneously buying another overpriced
security from the same dealer.
5.1.7) Unique Circumstances


Reading 13

Managing Institutional Investor Portfolios

Generally, banks do not have any common unique
circumstances related to their securities portfolio.
However, some unique circumstances that may affect
lending activities of banks include:
• Historical banking relationships;
• Geographically concentrated or risk-factor
concentrated loans: Increased lending to lowincome community, or agricultural loans etc.
• Community needs;
• Area where it is located: A bank situated in a small
community may have customers (depositors) who
deposit money with it primarily for the sake of
convenience and may face less competition. By
contrast, banks situated in highly populated areas
have more interest-rate sensitive deposits and face
high competitive pressures from nearby banks.
• Inability to sell loans;

5.2

Other Institutional Investors: Investment
Intermediaries

Instead of investing their own funds like pension funds,
foundations, insurance companies etc., institutional
investors pool and invest investor funds. Other
institutional investors include:
A. Investment companies: These refer to pure investment
vehicles where pooled funds of investors are invested
in equity and fixed-income markets e.g.
• Mutual funds (open-end investment companies);
• Closed-end funds (closed-end investment
companies);
• Unit trusts;
• Exchange-traded funds;
B. Commodity pools: They refer to investment vehicles
where pooled investor funds are invested in
commodities futures and options contracts rather
than equity and fixed-income markets.

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C. Hedge funds: Hedge funds are the investment
vehicles, which are only available to institutional
investors and to high-net-worth individuals. They are
not highly regulated.
D. Nonfinancial corporations (i.e. businesses): They
primarily invest in money markets instruments (fixedincome securities with maturities of ≤ 1 year) primarily

for cash management purposes. Cash can be
divided into two types:
i. Liquid cash: It refers to cash invested in demand
deposits and very short-term money market
securities.
ii. Long-term or Core cash: It refers to cash invested in
longer-term money market securities.
• From cash management perspective, the primary
investment objective of non-financial corporations
as well as the financial institutional investors is to
actively manage the composition of the cash
position in a manner consistent with liquidity needs
(including seasonal cash needs), nondomestic
currency needs, tax concerns as well as safety of
principal.
It is important to understand that unlike other types of
institutional investors, we cannot generalize about the
investment objectives and constraints of these types of
institutional investors. For example, each mutual fund
would have its specific investment objectives and
constraints.

Practice: End of Chapter Practice
Problems for Reading 13 &FinQuiz
Item-set ID# 12424.