238 INSURANCE COMPANY INVESTMENTS

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1 238 INSURANCE COMPANY INVESTMENTS S. DAVIDSON HERRON, JR. Investment departments have traditionally been set apart in our indt, stry to protect the assets built up in the business and to earn a return both on these funds and on the additions generated by volume growth and retained earnings. The separate character of the department has developed for a number of reasons. The nature of the inst, rance side of the business is such that practically all ot, tlays are viewed as expenses to be controlled, and the nature of the investment side is such that practically all outlays are considered as investments to be encouraged. Thus there is a minimum of competition for the privilege of spending the company's money. The legitimate desire to keep investment results out of inst, rance rates has also contributed to the isolation of the investment function. For the stock companies, another wedge between t, nderwriting and investment has been the traditional relationship of dividend disbt, rsements to net investment income. For the insurance security analyst, there are often two separate companies under one corporate roof -the insurance company and the investment company. (The stockholder cannot enjoy this sophistication. For him there is only one.) The analyst spends most of his time delving into the distinctions between one company and another in underwriting, but presumes that a particular financial position establishes limits on the investment results of a company from which individual departures are not significant enough to measure. Even if he were to analyze the relative investment result, he might not consider the past to be as reliable an indication of the future as he wot, ld in appraising the insurance operations. From what has been said thus far, it might be conclt, ded that the investment manager has the best of all possible worlds-he is set apart from the problems of the insurance business, his fellow executives make every effort to maximize the money he has to spend, and no one seems to measure the result of his efforts! For any investment man whose view of his responsibilities is this comfortable, 1 need hardly advise that he should never sell a bond at a ]oss if it is amortizable, and should always add to common stock carried at a low cost. Neither precept is guaranteed to produce a good result, but will, nonetheless, present a favorable appearance. Editor's Note: This paper was presented by invitation. Mr. Hcrron is Vice President of the lnst, rance Company of North America.

2 INVES'rM ENTS 239 The real job of investment management must be described in more aggressive and less anaiable terms. The challenge is to improve the financial position of a company relative to its competitors, so that, year by year, it is gaining on them in its ability to add to premium volume, to stand large insurance exposure, to innovate, to raise capital, to acquire companies, and to increase dividends. Because of the deterioration of underwriting profit margins, investment results seem to be drawn more and more directly into the competitive problems of the industry. Before the portfolio manager can make useful decisions, there are several major factors he must take into account in pursuing his investment polices. These would be: (I) State insurance laws (2) Tax laws (3) Financial position (4) Liquidity requirements, and (5) Market conditions The first of these-state insurance laws-has a negligible influence on the day-to-day investment activities of responsible companies in the business. Typically, such laws prevent investments which common sense would discourage and require investments that prudence would suggest. For instance, we are required to invest an amount at least equal to the par value of the common stock of our company in U.S. Treasury obligations, state and municipal general obligations or Federal Housing Authority bonds. On the other hand we are prevented from lending money to individuals or investing in insolvent corporations. Investment in real estate must be limited to those properties necessary for the conduct of the insurance business. One state in which we do business influences our investment decisions indirectly by permitting us to avoid certain premium taxes, provided we deposit with it general obligations of that state in an amount related to the premium volume generated within that state. Another state over-reaches in this same effort to encourage investment in its debt by relating the share of premium taxes it will forgive to the share of the company's investments represented by tax-exempts issued from within that state. As you might expect, the encouragement is disregarded in a national company, or, if business in that state is large enough, a separate subsidiary is established there. One aspect of state regulation of investments which individual companies have examined carefully in recent years has been general discouragement of controlled and managed investments in other businesses. When

3 240 INVESTMENTS companies have considered major moves into investments in other financial services, they have frequently found that it would be desirable to establish a holding company that would separate the stock of the insurance company from the other operations. If capital supporting the stronger insurance companies is drained away into these other activities, it should have a profound effect on the bt,siness. From time to time there are suggestions that state laws should be more restrictive on investments, and there is always available to frighten small children the mythical company that is recklessly gathering in premiums so it can speculate in the stock market and parlay its inadequate capital funds. Capital is leaving the business, by liquidation, common stock repurchase, and diversification. A tightening of state laws governing the investments of the business would accelerate the withdrawal of responsible capital, weakening the strong and providing a useless remedy for the weak. Turning now to the impact of tax laws on investment decisions, it is worth noting that neither the stock companies nor the mutual companies benefit from any significant tax concessions, nor do they suffer from any peculiar tax burdens. We pay the full corporate rate (48%) on income from U.S. Government securities, corporate debt securities and foreign securities. As is true for all corporations, domestic state and municipal obligations are exempt from tax and an 85% dividends-received credit reduces the effective tax rate on most domestic preferred stocks and all domestic common stocks to 7.2%. Relative yields tend to rellect these differences, but not fully, so that a profitable insurance company will usually minimize its investment in taxable corporate and foreign bonds, maximize its investment in tax exempts and carry a heavy position in preferreds. One curious effect of institutional buying patterns is that the preferred stocks of many companies yield less than the bonds that are senior to them. Some insurance companies do not make great use of preferred stocks in their portfolio, partly because they must be priced at market, but if this is not a consideration, they usually provide more yield after tax than municipals of equivalent quality. The impact of the capital gains tax has been manifold. For gains taken in six months, or more, during a year when a company is on a current tax basis, the tax is 25%. If the gain is taken in less than six months, or if the company is on a non-current tax basis, the effective tax is 48%. This tax has encouraged the purchase of yield stocks rather than growth stocks, since most of the dividend can be retained or funneled through, but only three-quarters of the profit can be kept. It has contributed to overdiversification, since few sales seem to make sense at the time if a sub-

4 INVESTM ENTS 24 l stantial capital gains tax must be paid. It has justified considerable activity in securities that can be sold at a loss, since in a large portfolio it is almost impossible to avoid realizing gains, which it would be neglectful to fail to try to offset. As statutory underwriting results have deteriorated, more and more companies' results are not only too poor to be taxable, but so poor that the losses can be applied against the earnings of certain other years. The three years immediately prior to the loss year are the first step in the search and the taxes incurred in those years can be recovered from the Government. If the losses are too great to be absorbed by the profits of these three years, they are eligible to reduce the taxable income of the succeeding five years. If these losses continue, a company will build up a series of carry-overs that expire in different years. At some point in these unfortunate developments, the appeal of tax-exempt securities is lost, and taxable bonds take their place. The shift is a delicate maneuver because it is exhausting carry-over while it is underway. It is also delicate in the sense that it is not evidence of much confidence in the underwriters and producers. The last phase in the transition is the sale and repurchase of common stocks so that capital gains are realized just before a carry-over expires. This activity has the effect of writing up the tax cost of the portfolio. While it may at first seem a useless exercise, a portfolio with a potential tax liability becomes more valuable when that liability is removed. It would seem that an actuarial department would be of considerable assistance to the investment manager groping his way toward a policy that would make sense in the early stages of a carry-over. Turning now to the influences of the financial position of a company on its investment policies, it could be summarized by citing a recent article by Allan Comrie, of Great American Insurance Company, in which he remarked that "Insurance exposure and investment exposure should vary inversely." You may be familiar with a rule of thumb that says that assets equal to the sum of the loss reserve and the unearned premium reserve should be in cash, agents' balances and fixed income securities. There are a number of variations to this which consider the equity in the unearned premium reserves and redundancy in the loss reserve, or which exclude preferreds or non-rated bonds from the offsetting assets. In other words, the measure is adaptable to management's desires. As the ratio of net worth to liabilities increases, and as the profitability of the business improves, investment judgment should take over and asset allocation should be disregarded. If the company is not financially strong, has poor operating results, and is not generating funds, then a more conservative

5 242 INVESTMENTS attitude than that embodied in the rule of thumb may be called for, since capital adequacy is in doubt and liquidity needs become a factor. If fixed income seems called for very heavily, it is interesting that the investment manager will often accept a lower credit portfolio to reach for results ordinarily denied him by the category. Where the manager has a number of options, the temptation to speculate in the bond account is minimal. Capital adequacy is perhaps the single most important influence on investment policy. Reviewing the record of the past 10 years, it can be shown that most additional capital was raised (either in the market or through acquisition of an overcapitalized or liquidating company) when a company's net worth was between 40 and 45% of its liabilities. This is probably the best measure of minimum capital. If a company in this position were to invest its capital funds in common stocks, and were to suffer simultaneously a sharp market decline and a bad underwriting year, the potential of the company would be severely damaged. Companies with a more substantial capital position can afford the risk associated with full investment of their capital funds in common stock, and as we move toward the over-capitalized companies, it is not uncommon to find the value of equities in the portfolio exceeding the capital funds. Liquidity is the next factor which was listed at the outset of this discussion. Insurance companies may need money fast for a number of reasons. They may be concerned about the ability to pay off a catastrophe loss quickly. They may want to buy in some of their own stock. They may want flexibility in shifting between taxables and tax-exempts. They may work their cash so hard that there is a frequent call on invested funds. Or, they may simply be losing cash in poor underwriting results without volume growth. Government bonds of any maturity are highly liquid, and an excellent vehicle for any of these requirements. A maturity schedule for all bonds may be established to augment the cash flow. A line of credit may be established for quick access to funds. Now that banks are active borrowers for capital needs, there is every reason to expect that insurance companies will change their attitude about debt. The healthier the company, the less it must consider liquidity, for a strongly positive cash flow should take care of the needs of the business. A maturity schedule in such a case is unnecessary, and only provides the manager with an excuse for hiding behind a formula. From what has been discussed so far, perhaps some insight has been gained into why there is such a variety of ways in which different companies' investments are distributed. Circumstances change enough that

6 INVESTMENTS 243 from decade to decade, the portfolio pattern will vary considerably, so that what you have learned today will be obsolete not many years from now. One lesson that may last longer is one we all knew anyway: the rich get richer. More particularly, the weak companies with poor underwriting results must maintain relatively conservative portfolios, and their opposites can be just as aggressive as they please. Whether this advantage is real or imaginary depends on the relative qualities of the managers. You may have heard of the studies supporting the belief that a random selection of equities performs as well as a portfolio professionally administered. Obviously, this is nonsense. I don't know any investment managers who agree with it. Oh, yes, there was one chap-but he was about to retire.