How Property/Casualty Insurance Companies Invest Premium Dollars

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1 How Property/Casualty Insurance Companies Invest Premium Dollars OVERVIEW Every day, property/casualty insurers enable our economy to function by helping individuals and businesses address the various risks they face. In doing so, insurers take in premiums based on anticipated loss costs, keeping a small portion to cover operating expenses, and investing the rest until needed to pay claims or to hold aside to cover extraordinary losses. Thus, in addition to handling the risk of their policyholders and the larger society, insurance companies also have to be prudent and careful investors by managing the risk of the invested premium dollars. Because of the uncertainty and volatility of underwriting results, these investment returns can be a key source of financial stability for insurers in a competitive market. The industry s investment practices are geared towards being able to compensate policyholders quickly and efficiently, a business model that is also reinforced by statutory requirements. The majority of property/casualty assets are invested in stable and liquid investment categories, including more than two-thirds in fixed-income debt securities (with 57 percent of this amount being invested in conservative and relatively safe municipal and government bonds). See Section 1 for further detail on overall invested assets and Section 2 for further detail on debt securities. Overwhelmingly, the property/casualty industry s fixed income investments are highly rated, with over 90 percent corresponding to the NAIC s SVO Class 1 rating and nearly 8 percent corresponding to the Class 2 rating. The Class 1 rating roughly corresponds to the S&P AAA through A- public bond ratings. See Section 3 for the percentage of each rating. When compared to all other investors in various classes of investments as tracked by the Federal Reserve Board, property/casualty insurance companies are among the largest holders of municipal bonds, but rank lower in terms of holdings in corporate and foreign bond holdings and U.S. corporate equities. See Section 4 for full listings of all investors in these classes of securities. The following sections provide further detailed information on property/casualty insurance investments in various subject areas: Section 1: Overall Investment Breakdown (p. 2) Section 2: Fixed-Income Debt Securities Breakdown (p. 3) Section 3: P/C Debt Securities Holdings Measure of Quality (p. 4) Section 4: Comparing Property/Casualty Industry to All Other Investment Holders (p. 4) Section 5: Statutory Restrictions on Property/Casualty Insurer Investments (p. 6) 1

2 Section 1: Overall Investment Breakdown Because claims can come due suddenly and unexpectedly, the property/casualty business requires stable and liquid investments. The diagram below demonstrates this need for conservative investments. In 2008, the most recent year of data available, the property/casualty industry had an aggregate of $1.2 trillion in invested assets. Approximately 69 percent (or $862 billion) of these assets were in fixed-income debt securities, while approximately 16 percent (or $200 billion) were in equity securities (such as common stocks), approximately 14 percent (or $168 billion) were in cash/cash equivalents and other invested assets, and 1 percent (or $16 billion) were in real estate/mortgage loans. Examples of other invested assets include intangible rights, capital notes, variable interest instruments, joint venture interests, and leases. U.S. Property Casualty Industry: Invested Assets, 2008 Cash / Other 14% Real Estate and Loans 1% Equity 16% Debt Securities 69% Source: Aggregates & Averages, A.M. Best 2

3 Section 2: Fixed-Income Debt Securities Breakdown Because of the potential volatility of their losses, property/casualty insurers must necessarily adopt a conservative investment strategy in order to ensure sufficient assets are available at any given time to meet their obligations to policyholders. Looking more closely at the debt securities side, approximately 57 percent ($493 billion) of debt securities investments were in conservative and relatively safe municipal bonds and U.S. Treasury or government agency securities. Other fixed income securities makes up about 24 percent ($205 billion) of the industry s debt securities investments. Mortgage-backed bonds make up about 19 percent ($164 billion) of the remaining debt securities. U.S. Property Casualty Industry: Debt Securities, 2008 Treasury/ Government Agency Bonds 13% Mortgage Backed Bonds 19% Municipal Bonds 44% Other Fixed Income 24% Key: Source: Aggregates &Averages,A.M. Best Treasury/Government Agency bonds consist of debt securities issued by the United States Treasury, agencies of the United States, agencies sponsored by the United States, and agencies of foreign governments. Municipal bonds consist of general obligation bonds, revenue bonds, and industrial development bonds issued by states, territories and their political subdivisions. In 2008, property/casualty insurers held more than 146,000 separate bond issuances for all 50 states and the District of Columbia, according to A.M. Best. These state investments provided capital for state/local government and public projects, including schools, roads, libraries, hospitals, and affordable housing. For example, in a 2007 report, the Insurance Research Council estimated that 23 percent of the p/c industry s municipal bond holdings were in education-related activities and projects. Insurers also purchase general obligation bonds to finance ongoing government operations. Mortgage-backed bonds consist of securities that are backed by commercial and residential real estate. Insurers typically invest in mortgage-backed securities that are issued or guaranteed by governmentsponsored enterprises such as the Government National Mortgage Association, Federal National Mortgage Association, and Federal Home Loan Mortgage Corp. Other fixed income securities include U.S. and foreign corporate bonds. 3

4 Section 3: P/C Debt Securities Holdings Measure of Quality Overall debt securities investments are overwhelmingly highly rated, as the chart directly below shows. Approximately 90.1 percent of the industry s debt securities ( total bonds ) are rated at the NAIC s SVO rating of Class 1 (roughly the equivalent of a AAA, AA or A S&P rating) and 7.7 percent are rated at Class 2 (roughly the equivalent of a BBB S&P rating). Only 2.2 percent of total bonds are rated below Class 2. P/C Debt Securities SVO Ratings, 2008 SVO Designation S&P Equivalent 1 % of total Class 1 AAA, AA+, AA, AA-, A+, A, A % Class 2 BBB+, BBB, BBB- 7.7% Class 3 BB+, BB, BB- 0.91% Class 4 B+, B, B- 0.91% Class 5 CCC+, CCC, CCC- 0.27% Class 6 CC, C, D 0.13% Source: A.M. Best Aggregates & Averages Section 4: Comparing Property/Casualty Insurers to All Other Investment Holders The property/casualty industry s conservative investment philosophy can also be seen in reviewing the classes of investors in various categories of securities as reported by the Board of Governors of the Federal Reserve in its periodic Flow of Funds Accounts of the United States. 2 The property/casualty industry is among the largest holders of municipal securities with about 14 percent of the total investment in municipal securities. Holdings of U.S. Municipal Securities and Loans, Sector Amount (billions) Percent of Total Household sector $ % Money market mutual funds $ % Mutual funds $ % Property/casualty insurance companies $ % Commercial banking $ % Closed-end funds $ % Life insurance companies $ % Rest of the world $ % Brokers and dealers $ % Government-sponsored enterprises $ % Savings institutions $ % Nonfarm noncorporate business $ % State and local governments $ % Nonfinancial corporate business $ % State and local government retirement funds $ % Total $2, Standard and Poor s Corporate Counterparty and Municipal Ratings Public Bonds. 2 Note that the Federal Reserve figures are for 2008 (Q4), but may vary from the property/casualty numbers in Sections 1 and 2 (taken from A.M. Best) for several reasons, including investment category classifications, accounting methodologies, data sources, and chronology. 3 The source for all three charts in Section 4 was Federal Reserve Statistical Release, Z.1 Flow of Funds Accounts of the United States: Flows and Outstandings, Second Quarter 2009, Sept. 17, 2009, pp

5 In terms of foreign and corporate bonds, however, the property/casualty industry has a much smaller piece of the overall holdings, with only about 2.4 percent of the total, ranking tenth overall: U.S. Corporate and Foreign Bond Holdings, 2008 Sector Amount (billions) Percent of Total Rest of the world $2, % Household sector $2, % Life insurance companies $1, % Commercial banking $ % Mutual funds $ % Funding corporations $ % Private pension funds $ % Government-sponsored enterprises $ % State and local government retirement funds $ % Property/casualty insurance companies $ % Money market mutual funds $ % Finance Companies $ % State and local governments $ % Brokers and dealers $ % Savings institutions $ % Closed-end funds $ % Exchange-traded funds $ % Credit unions $ % REITs $ % Federal government retirement funds $ % Federal government $ % Total $11,130.4 The property/casualty industry s share is even lower (1.2 percent) in U.S. corporate equities, such as common or preferred stock, ranking seventh among all investors. U.S. Corporate Equities Holdings, 2008 Sector Amount (billions) Percent of Total Household sector $5, % Mutual funds $3, % Rest of the world $1, % Private pension funds $1, % State and local government retirement funds $1, % Life insurance companies $1, % Exchange-traded funds $ % Property/casualty insurance companies $ % Federal government $ % Brokers and dealers $ % Federal government retirement funds $ % State and local governments $ % Closed-end funds $ % Savings institutions $ % Commercial banking $ % Total $15,

6 Section 5: Statutory Restrictions on Property/Casualty Insurer Investments While the economics of the business dictate that property/casualty insurers investment philosophies remain conservative, state law 4 also restricts how much can be invested in various investment categories. These state laws generally require insurance liabilities to be backed by investments in seven categories of assets: 1) Cash and cash equivalents. 2) High and medium grade investments in rated securities or investment pools. Note that there are limitations placed on investments in medium and lower grade securities. For example: o The aggregate amount of all medium and lower grade investments cannot exceed 20 percent of admitted assets; o The aggregate amount of lower grade investments cannot exceed 10 percent of admitted assets; o The aggregate amount of investments rated 5 or 6 by the SVO cannot exceed 5 percent o of admitted assets; or The aggregate amount of investments rated 6 by the SVO cannot exceed 1 percent of admitted assets. 3) Stocks traded on a qualified exchange (not to exceed 25 percent of admitted assets 5 or 100 percent of surplus some states have an investment ceiling that is lower than the 25 percent amount). 4) Foreign investments, other than investment pools, if highly rated. 5) Other investments with an SVO rating of 1 through 4, as long as the aggregate of all investments does not exceed the greater of the insurer s unrestricted surplus or the lesser of: o 10 percent of its admitted assets or o 50 percent of its policyholder surplus. 6) Interest and dividends receivable on qualifying investments. 7) Reinsurance recoverables (amounts due from reinsurers). Additionally, there are diversification requirements. For example, a property/casualty insurer generally cannot hold more than 3 percent of the insurer s admitted assets in investments issued, assumed, accepted, insured or guaranteed by a single person, or hold more than 5 percent of its admitted assets in the form of voting securities of a depository institution. AIA Policy Development & Research, February There are other investment limitations and states often have specific, unique restrictions. The purpose of the various restrictions is to ensure that the insurer maintains an adequate pool of assets that are sufficient to pay policyholder claims. 5 Admitted assets is a term used by insurance regulators to refer to assets that are included in the statutory balance sheet. Because insurance regulators focus on solvency and the insurer s ability to meet policyholder obligations, only assets with an economic value that is available to fulfill policyholder obligations are recognized on the balance sheet. For example, an asset such as a car or a plane is generally not readily available to meet policyholder claims and therefore is considered nonadmitted. Thus, an added layer of conservatism is provided by the restrictions, since they are based on admitted assets, rather than an insurer s total assets. 6