Insurance companies and pension funds as institutional investors: global investment patterns

SPECIAL INTEREST PAPER Report prepared for the City of London Corporation by Trusted Sources Published November 2011 Insurance companies and pension funds as institutional investors: global investment patterns City of London Economic Development PO Box 270, Guildhall, London, EC2P 2EJ www.cityoflondon.gov.uk/economicresearch

SPECIAL INTEREST PAPER Report prepared for the City of London Corporation by Trusted Sources Published November 2011 Insurance companies and pension funds as institutional investors: global investment patterns City of London Economic Development PO Box 270, Guildhall, London, EC2P 2EJ www.cityoflondon.gov.uk/economicresearch

Insurance companies and pension funds as institutional investors: global investment patterns is published by the City of London. The author of this report is Trusted Sources. This report is intended as a basis for discussion only. Whilst every effort has been made to ensure the accuracy and completeness of the material in this report, the author, Trusted Sources and the City of London, give no warranty in that regard and accept no liability for any loss or damage incurred through the use of, or reliance upon, this report or the information contained herein. November 2011 City of London PO Box 270, Guildhall London EC2P 2EJ http://www.cityoflondon.gov.uk/economicresearch

Table of Contents Foreword... 1 Executive Summary... 3 1. Introduction... 6 2. Developed Markets... 7 2.1. The dynamic of institutional investors in continental Europe is following the path established by the industry in the UK and the US... 7 2.1.1. Growth of the insurance sector has moved in line with economic development... 7 2.1.2. Pension funds in continental Europe have lagged behind those of the US and the UK but are following suit... 8 2.2. Regulations in continental Europe have been stricter than those in the UK and the US... 9 2.3. Investment patterns vary widely among countries... 10 2.4. Investment patterns are driven by country-specific factors... 14 2.4.1. Regulations... 14 2.4.2. Asset-liability matching... 14 2.4.3. Supply of assets... 15 2.4.4. Macroeconomic conditions... 16 2.4.5. Competition... 16 2.5. Pension funds and insurance companies have shaped financial systems... 17 2.5.1. Institutional investors drove the divergence of the Anglo-Saxon and continental European financial systems... 17 2.5.2. Institutional investors established London as an international financial centre... 18 2.5.3. Insurance companies drove the development of the US corporate bond market... 19 2.5.4. Institutional investors will continue to facilitate financial diversification in continental Europe... 21

2.6. Conclusion... 22 3. India... 23 3.1. The insurance and pension sectors are underdeveloped, but there is huge potential for growth... 23 3.1.1. Insurance sector... 23 3.1.2. Pension system... 25 3.2. Regulations... 26 3.2.1. Insurance companies... 26 3.2.2. Pension funds... 27 3.3. Insurance companies increasingly invest in equities; pension funds are still focused mainly on government securities... 28 3.3.1. Insurance companies... 28 3.3.2. Pension funds... 29 3.4. Investment patterns are driven by regulations, liability structures and the supply of assets... 30 3.4.1. Regulations... 30 3.4.2. Asset-liability matching... 31 3.4.3. Supply of assets... 32 3.4.4. Macroeconomic conditions... 32 3.5. Insurance companies and pension funds can contribute significantly to capital market development... 32 3.5.1. Financial system... 32 3.5.2. Stock market... 33 3.5.3. Corporate bonds... 35 3.6. Recommendations... 36 4. China... 38 4.1. The insurance and pension sectors are underdeveloped, but they have huge potential for growth... 38 4.1.1. Insurance sector... 38 4.1.2. Pension system... 39 4.2. Regulations... 40

4.2.1. Insurance companies... 40 4.2.2. Pension funds... 41 4.3. Insurance companies investments still consist mainly of bank deposits and fixed income; the main pension funds leave money in their dedicated savings accounts... 42 4.3.1. Insurance companies... 42 4.3.2. Pension funds... 43 4.4. Investment patterns are driven by regulations, liability structures and the supply of assets... 44 4.4.1. Regulations... 44 4.4.1. Asset-liability matching... 45 4.4.2. Supply of assets... 46 4.4.3. Other factors... 47 4.5. Insurance companies and pension funds can contribute significantly to capital market development... 48 4.5.1. Financial system... 48 4.5.2. Contribution to the stock market... 48 4.5.3. Contribution to the corporate bond market... 50 4.6. Recommendations... 51 5. Conclusions... 53 6. Appendix... 54 Glossary... 57

Foreword Stuart Fraser Chairman, Policy and Resources City of London The City of London s position as a global financial centre makes it a natural partner for growing economies such as India and China as they develop their financial sectors. Building on and deepening our existing cooperation in financial services with India and China is a critical element of the City of London Corporation s international programme, guided by our Advisory Councils for India and China respectively, and delivered by the City of London s offices in Beijing, Mumbai and Shanghai. UK financial services firms are longstanding participants in both the Indian and Chinese financial sectors. Participation by foreign firms in the Indian and Chinese insurance sectors has helped to share international practices and to build knowledge and skills in these markets. In the insurance sector, there are six joint ventures between Indian and UK firms, and UK insurers are among the leading foreign players in China. Foreign firms are also investors in India as Foreign Institutional Investors (FIIs) and in China through the Qualified Foreign Institutional Investor (QFII) scheme. Greater depth and liquidity in domestic capital markets is needed in both India and China to support the growth of their companies. Capital markets play a vital role in raising debt and equity capital for businesses, offering alternatives to bank financing and channelling funds from savers into the financial sector. The experience of London demonstrates the valuable role that robust capital markets can play in supporting a sophisticated and liquid market, attractive to both international investors and companies wishing to raise money. This report provides an exploration of the role played by institutional investors in sophisticated financial markets, and demonstrates the ways in which greater investment freedom and more varied asset allocations have provided vital liquidity to debt and equity markets in the UK, US and continental Europe. The report then considers the role that insurers and pension funds play in India and China, and the contribution they could make to increasing liquidity and depth in debt and equity markets in both countries. In India, insurance companies have increased their involvement in both equities and corporate bonds but could develop this further, aided by a range of potential measures which would help to realise their contribution. These would include: lifting restrictions on equity investments; allowing investments in lower-rated corporate debt and derivatives; allowing the Employees Provident Fund Organisation to invest in equities; removing tax and regulatory constraints on the development of the corporate bond market; and increasing incentives to buy corporate bonds. 1

In China the role of both insurance companies and pension funds in the stock market is very small, with a somewhat greater presence in the corporate bond market. Measures that would help to realise the potential contribution of pension funds and insurance companies to China include: encouraging competition among insurance companies; providing tax incentives for Unit Linked Insurance Products; introducing effective dividend pay-out rules for listed companies; encouraging the development of expertise of fund managers in insurance companies; and relaxation of qualification rules for private companies allowed to issue bonds. Efficient financial intermediation is essential to provide depth to the Indian and Chinese debt and equity markets, which will in turn provide capital to Indian and Chinese businesses for their domestic and international expansion. This report draws out a number of important issues and recommendations as to how institutional investors can support the growth and success of the Indian and Chinese economies. We look forward to continuing to work with government officials, regulators and businesses in both countries to help to realise this potential. Stuart Fraser London November 2011 2

Executive Summary Pension funds and insurance companies have shaped financial systems in the developed world. In China and India, their involvement in capital markets so far has been limited. This paper explores the role they could play in the deepening of equity and corporate bond markets by making comparisons with and drawing lessons from developed markets. In the UK and the US, pension funds and insurance companies grew very rapidly as the financial system became more sophisticated and people cared more about saving for their retirement as they grew richer. In the UK, pension assets grew from 20 per cent to 80 per cent of GDP and insurance company assets increased from 20 per cent to 100 per cent of GDP between 1980 and 2009. At the same time, pension funds and insurance companies started to invest more in equities and, in the US, in corporate bonds instead of government bonds. As a result, huge amounts of stable, long-term funds were channelled into capital markets. In the UK, these funds drove the development of the stock market into one of the most liquid and sophisticated financial centres in the world. Before foreign investors became significant shareholders, pension funds and insurance companies held over 60 per cent of issued shares. In the US, institutional investors not only contributed to the deepening of equity markets but were also central to the development of the corporate bond market, now the largest in the world at 140 per cent of GDP. In most of continental Europe, the role of institutional investors has historically been much smaller. Pension funds remained small because extensive pay-as-you-go (PAYG) systems were in place. Moreover, investments remained much more focused on government bonds, partly because regulations were much stricter than in the UK and the US. As a result, the financial system remained centred on bank lending. More recently, however, institutional investors have grown and have diversified their investments into equities and corporate bonds. This has facilitated a move towards market-based financing. In India, insurance companies have increased their involvement in both equities and corporate bonds. They currently hold the equivalent of 11 per cent of free-float market capitalisation. Compared to the US and the UK, however, their participation is still limited. Pension funds barely invest in equities and not in corporate bonds at all. The potential for an increased role is large: The pension and insurance sectors are still relatively underdeveloped, with assets at 7 per cent and 16 per cent of GDP respectively. High growth is expected as the economy matures, as happened in the UK and the US. If insurance companies grow to the size of those in the UK and retain the same asset allocation, they will hold six times as many shares equivalent to 60 per cent of current market capitalisation. Much room exists for insurance companies and pension funds to shift asset allocations from government bonds to equities and corporate bonds. India s high-growth, high-inflation environment makes equity investments attractive, especially because government bonds hardly yield a positive real return. This 3

explains the enormous growth of index-linked insurance products (ULIPs), a trend expected to continue. Nonetheless several major restrictions are still in place in India: Regulations are preventing insurance companies from investing more in equities and are blocking their investment in lower-rated corporate bonds, including infrastructure bonds, and derivatives. Pension funds are even more restricted: the Employees Provident Fund Organisation (EPFO), which accounts for two-thirds of the pension fund market, is not allowed to invest in equities at all. The supply of (long-term) corporate bonds is not sufficient to meet the demand from insurance companies. Some tax and regulatory issues are slowing the growth of the market. Some recommendations to realise the potential contribution of pension funds and insurance companies are: Further liberalising investment regulations for insurance companies. This would include lifting restrictions on equity investments and allowing investments in lower-rated corporate debt and derivatives. Insurance companies told us they feel that they have adequate resources to manage risk, particularly as the involvement of foreign companies has helped to build expertise. Allowing EPFO to invest in equities and further liberalising rules as the sector matures. Removing the remaining tax and regulatory constraints on the development of the corporate bond market and increasing incentives to buy corporate bonds. In China, the role of both insurance companies and pension funds in the stock market is very small: each holds only around 2 per cent of issued shares. Insurance companies play a bigger role in the corporate bond market, holding about onethird of total non-financial bonds outstanding. Pension funds holdings are negligible. However, insurance companies and pension funds are likely to start playing a larger role: As in India, the rapid growth of the pension and insurance sectors is expected to continue. If insurance companies keep growing at their current rate and increase their equity holdings to the maximum 25 per cent allowed, they will hold more than four times as many equities in three years' time. Asset allocations are still very conservative. Insurance companies invest only about 11 per cent in equities; they hold the rest in bank deposits and bonds. The Urban Basic Pension Fund (UBPF), the largest segment of the pension system, keeps almost all funds in dedicated savings accounts and does not invest in equities. If asset allocations became more similar to those in the UK and the US, this would constitute a major shift of funds into the stock and corporate bond markets. 4

Asset allocations in China have been conservative and could remain that way for three major reasons: Most insurance policies are participating or ordinary products that offer a guaranteed return of only 4 per cent and 2.5 per cent respectively. Government bonds and negotiated-term deposits provide these returns with very limited downside risk, giving little incentive to insurance companies to diversify their investment portfolios. ULIPs occupy only a marginal position. If they increase in popularity, as happened in the UK and the US when competition increased, a shift into equities is expected. The restrictions on equity and corporate bond investments by insurance companies are currently not truly constraints, but the limitations on private equity, real estate and derivatives are. The rules governing the Urban Basic Pension Fund prevent any investment in equities. Insurance companies find the stock market too volatile to invest in and complain that not enough dividends are paid out. The main constraint on more investment in corporate bonds is a lack of supply. Strict regulatory control over bond issuance is restricting growth. To stimulate the greater participation of pension funds and insurance companies in capital markets, some measures are recommended: Encouraging competition among insurance companies and/or providing tax incentives for ULIPs. Adopting effective dividend payout rules for listed companies, such as making only companies that pay dividends eligible for secondary offerings. Encouraging the development of expertise of fund managers in insurance companies (for example, through greater collaboration with foreign insurance companies) so as to increase their confidence to invest in riskier asset classes. Relaxation of qualification rules for private companies allowed to issue bonds. 5

1. Introduction Pension funds and insurance companies have been central to the development of capital markets in the UK and the US. By contrast, their role in India and China so far has been limited because of the evolving nature of the insurance and pension sectors and the restrictions put on their investments. In view of those countries desire to deepen and to diversify their financial markets, this paper explores how insurance companies and pension funds could contribute to this. It analyses the experience of developed markets, compares and contrasts this to China and India and derives implications and lessons for future progress. To do so we draw on data analysis as well as interviews with insurance companies, pension funds and regulators in China and India. Three major chapters analyse the experience of developed markets, India and China respectively. Each chapter consists of six sections. The first describes the dynamics of the pension and insurance sectors in the respective markets. It explains why institutional investors have grown so rapidly in the UK and the US, how this compares to the status quo in India and China and what it implies for future growth in these countries. The second section describes the regulatory frameworks, including how and why they differ. The next section compares the investment patterns in the UK, the US and continental Europe in order to highlight trends over time and differences among countries and investors. These developed market patterns are then used as a basis for comparison with China and India s asset allocations. The third section turns to the drivers of these investment patterns. It reviews factors such as the composition of liabilities, macroeconomic conditions, competition and risk aversion. Special attention is given to the effect regulations have had on asset allocations. Having pointed out why pension funds and insurance companies invest in the way they do, we draw implications for future investment patterns in India and China. Then we investigate how institutional investors have shaped the financial systems in the UK and the US and their more recent contribution in continental Europe. We compare this to the role pension funds and insurance companies play in India and China and examine what potential this implies for the future. In the final section, we discuss what policy action is required to realise this potential. 6

2. Developed Markets 2.1. The dynamic of institutional investors in continental Europe is following the path established by the industry in the UK and the US 2.1.1. Growth of the insurance sector has moved in line with economic development As countries grow richer, they tend to develop more active insurance sectors. For example, insurance assets in the UK grew exponentially from 20 per cent of GDP in 1980 up to 100 per cent of GDP and have stabilised at around that level in the past decade (see Chart 1 below). France's insurance sector has seen an even more spectacular rise, and its size now rivals that of the UK. The trend of growing insurance sectors is universal, but other factors affect its size as well. In the US, the insurance sector seems to have stabilised at around 40 per cent of GDP and in Germany at 60 per cent. In the southern European countries, insurance penetration is still relatively low, but strong growth is expected over the next decade. In most countries life insurance dominates the sector. This includes policies that pay out a sum either at death or at a specified time in the future and annuities, regular payments that are made until death. In principle, these are simply long-term saving products and are therefore in some ways similar to, and compete with, pension savings (as well as other saving products). Chart 1: Insurance companies assets as share of GDP, 1980-2009 Sources: OECD, TS calculations. 7

2.1.2. Pension funds in continental Europe have lagged behind those of the US and the UK but are following suit The size of pension funds varies much more widely among countries. There are clearly two camps here: the UK and the US, which have huge pension funds, and the continental European countries, 1 where they are tiny (see Chart 2 below). The reason behind this divergence is that in most continental European countries the state has operated a generous pay-as-you-go (PAYG) pension system in which current workers are taxed to pay out current pensions, and thus no assets are accumulated. State pensions are also in place in the UK and the US, but they are so small that as people grow richer they start to accumulate savings through private (occupational) pension funds to ensure sufficient retirement funds. As the population of most developed countries is ageing, PAYG systems will put considerable strain on government finances and eventually become unsustainable. Therefore governments are increasingly aiming to switch from PAYG systems to (private) fully funded systems. This has already resulted in significant growth of European pension funds, but the process is just beginning. As fully funded systems are the model of the future, an enormous accumulation of pension assets is expected. Chart 2: Pension fund assets as share of GDP, 1980-2009 Sources: OECD, TS calculations. 1 Continental Europe should be taken to mean Germany, France and the southern European countries (Italy, Spain, Greece and Portugal). Most of the trends discussed do not hold for some of the smaller European countries, most notably the Netherlands, whose insurance and pension sector is more similar to the UK s. 8

2.2. Regulations in continental Europe have been stricter than those in the UK and the US Regulations governing what insurance companies and pension funds can invest in have historically also differed between continental Europe on the one hand, and the UK and the US on the other hand. In continental Europe s civil law tradition, in which rules are codified, quantitative restrictions were generally applied to institutional investors investments. By contrast, in the common law tradition of the Anglo-Saxon countries, "prudent person rules" were adopted early on. These require companies to make their investments prudently, i.e. to invest their assets in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole. In principle, therefore, prudent person rules leave investors with much more freedom. However, early interpretations focused on the need to protect beneficiaries from speculative investments and allowed investments only in government securities. In the UK, legislation was made more flexible in 1961, and all investment restrictions were removed in 1995. In the US, the prudent person rule was made more flexible for pension funds in 1974, but restrictive standards prevailed for non-pension trusts until the late 1980s. The rationale for the very strict regulations was that the individual s funds needed to be protected. The focus was on capital preservation rather than achieving high returns on investment. But as the financial sophistication of both governments and individuals grew, it became realised that it was not in the individual s best interest to invest as conservatively as possible at the expense of returns. Pension funds and insurance companies were therefore increasingly allowed to take more risk. With the advance of modern portfolio theory, there was greater acknowledgement that it was important to take a full portfolio approach to risk management, in which the correlation between assets and liabilities is taken into account. This implies that the risk of an asset can be assessed only in the context of the full portfolio, and therefore restrictions on individual asset classes make less sense. Moreover, modern portfolio theory highlighted the need to diversify and hedge risk, and thus provided an argument to allow investment in more asset classes such as private equity, foreign assets and real estate as well as in derivatives to hedge risk. Over time, investment restrictions on such instruments have therefore been lifted. In most of continental Europe, restrictive quantitative restrictions stayed in place when rules were liberalised in the UK and the US. Governments in continental Europe were generally more risk-averse, giving priority to financial stability rather than higher returns. Moreover, the insurance and pension sectors were less developed than in the UK and the US, so that risk management and supervisory expertise were lacking. This made it more difficult to enforce prudent person rules. Over time, however, regulations have been liberalised in all countries. The European Commission s IORP Directive of 2003 required all member states to adopt prudent person rules for pension funds. Member states are still allowed to impose some quantitative restrictions, but these cannot restrict investments in equities to below 70 9

per cent or foreign investments to below 30 per cent, nor can they put any restrictions on investing in risk-capital markets. 2 Some European countries still have quantitative rules in place for insurance companies, but in general there is a move towards fewer restrictions. This includes the relaxation or lifting of restrictions on investing abroad, in derivatives, in real estate, in mutual funds and in private equity. 2.3. Investment patterns vary widely among countries The following trends are evident in the investment patterns of insurance companies and pension funds, as illustrated in charts 3 to 7 below: In continental Europe, insurance companies and pension funds have had a much more conservative asset allocation than their counterparts in the UK and the US (see Chart 3 for 2009 pension fund data). A large share of investment has gone into government bonds; generally, less than 20 per cent of assets were in equity. More recently the importance of equity and corporate bond investment has increased, but is still low compared to the UK and the US. Chart 3: Asset allocation of autonomous pension funds, 2009 Source: OECD In the UK, investments of both insurance companies and pension funds have been highly geared towards equities. The share of assets in corporate securities has increased since 1960 to around 60 per cent from 50 per cent for pension funds and to 70 per cent from 40 per cent for insurance companies. 2 Equity financing to a company during its early growth stages (start-up and development). 10

This has come at the expense of government securities, which currently only account for about 10 per cent for pension funds and 15 per cent for insurance companies (down from 35 per cent and 25 per cent in 1980 respectively). Investment in corporate bonds has increased but is still very limited at 10 per cent (see Chart 4). Overseas investment has grown significantly since the 1980s, now accounting for about one-third of total investments. Insurance companies have a higher allocation to fixed-income instruments and less investments abroad than pension funds (see charts 4 and 5). Chart 4: Allocation of corporate securities by UK pension funds, 2000-2009 Source: UK National Statistics. 11

Chart 5: Allocation of corporate securities by UK insurance companies, 2000-2009 Source: UK National Statistics. In the US, pension funds have increased their asset allocation to equities from 30 per cent in 1980 to 50 per cent in 2007, before retreating during the financial crisis (see Chart 6 below). The share of bond investments decreased steadily up to 2007, after which it increased. The investment pattern of US pension funds was thus broadly the same as those in the UK (although UK pension funds invest in equities a bit more aggressively and US pension funds are more active in corporate bonds). On the contrary, insurance companies in the US have invested much more in bonds than their UK counterparts have (see Chart 7). Before 1940 their portfolios were dominated by government bonds, but from the 1940s they increasingly moved to corporate bonds. They invested as little as 10 per cent in equities up to 1990, but have since increased their allocation to around 25 per cent. 12

Chart 6: Asset allocation by US pension funds, 1980-2009 Source: The Conference Board. Chart 7: Asset allocation by US insurance companies, 1980-2009 Source: The Conference Board 13

Although investments in Europe, the US and most other OECD countries have increasingly diversified and moved away from government bonds, there are exceptions to this trend. In Singapore, the Central Provident Fund (CPF) an extensive social security framework in which workers are obliged to contribute 20-25 per cent of their salary invests almost exclusively in government bonds. Individuals are allowed to use some of their CPF savings to invest in equities, but the amount is limited and accounts for less than 2 per cent of stock market capitalisation. 2.4. Investment patterns are driven by country-specific factors The divergent investment patterns described above can be explained by many factors. This section discusses the most important ones. 2.4.1. Regulations Regulations have affected investments in the following ways: In the 1970s and 1980s regulations in the US were still relatively strict. This prevented insurance companies in particular from shifting investment into equities (which they wanted to do for reasons explained below). It was not until the 1990s, when regulations were relaxed, that a major shift into equities was made possible. One of the reasons why pension funds and insurance companies in continental European countries invested less in equities is that they were not allowed to do so. The relaxation of these restrictions has allowed them to invest more in this asset class. For most countries, however, restrictions were not binding, and other factors described in the next sections caused the conservative investment strategies. In the UK, the lifting of restrictions on investment abroad and in derivatives has allowed a significant part of assets to be invested abroad and for derivatives to become a major tool in controlling risk. Being able to hedge some elements of risk has made riskier assets such as corporate bonds more attractive. Lifting restrictions on specific asset classes, such as foreign assets, real estate, private equity and derivatives, has caused a shift into these assets in other countries as well. 2.4.2. Asset-liability matching The balance sheets of insurance companies and pension funds are exposed to risks both on the asset and the liability sides. For this reason, they will try to some degree to match assets and liabilities in terms of return, risk-profile and maturity in order to minimise their exposure. Naturally, the composition of liabilities will affect the optimal asset allocation. Historically most policies sold by life insurance companies had pay-offs defined in nominal terms. These long-term nominal liabilities were best matched by long-term bonds, which guarantee a fixed nominal return with limited downside risk. However, 14