ForewordAIMR is pleased to publish the proceed-ings of the sixth annual joint SAAJ-AIMR seminar, which was held April18-20, 1994, in Tokyo. For the secondyear, the proceedings have been pub-lished in both Japanese and English, al-lowing a wide audience of investmentprofessionals worldwide to benefit fromthe seminar.

The theme of this year's seminar wasinvestment policy-the first stage of theportfolio management process. The im-portance of setting investment policy hasgrown for institutional clients as themanagement of these assets has becomeincreasingly complex and the invest-ment environment increasingly volatile.The sessions of this seminar thus focusedon how investor objectives, constraints,preferences, and market expectationstranslate into appropriate portfolio poli-cies and strategies. The presentations inthis proceedings discuss primarily theneeds of large institutional clients-pen-sion plans, insurance companies, and en-dowment funds-as they wrestle withvarious aspects of the vital process ofestablishing investment policy.

We are especially grateful to Gen-taro Yura and the SAAJ Seminar Com-mittee for their tireless efforts in organ-

Katrina F. Sherrerd, CFASenior Vice PresidentEducation

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lzmg and managing the seminar.Thanks also go to the moderators,Mamoru Aoyama of the SAAJ and Don-ald L. Tuttle, CFA, of AIMR, and to allother participants in the seminar fromthe SAAJ-Nobumitsu Kagami, Nori-kazu Minoshima, Toshio Kasahara,Akira Suzuki, Tsutomu Tsuchihashi,and Shoji Yamada.

We would like to thank the speakerswho contributed to the seminar and pro-ceedings: Keith P. Ambachtsheer,K.P.A. Advisory Services, Ltd.; CharlesD. Ellis, CFA, Greenwich Associates;John L. Maginn, CFA, Mutual of OmahaInsurance Company; David F. Swensen,Yale University Investments Office; andJohn R. Thomas, CFA, J.P. Morgan TrustBank, Ltd. Special thanks go to KeithAmbachtsheer, Don Tuttle, and RichardD. Crawford, president of New VisionFinancial, for their contributions to thecase and analysis.

Finally, we also offer our gratitudeto Jan R. Squires, CFA, for his outstand-ing editing of this publication and in-sightful overview.

We hope you find this book valu-able as you investigate or rethink thepivotal role appropriate investment pol-icy plays in investment management.

Investment Policy: An OverviewJan R. Squires, CFAProfessor of Finance and General BusinessSouthwest Missouri State University

Change in the investment industry,which was already proceeding at asteady pace, has accelerated at a seem-ing breakneck speed during the pastdecade. The quickening of evolutionaryprocesses in the industry has been fu-eled by many phenomena, two of themost notable being the development ofportfolio management as a systematicprocess and the virtual elimination ofnational and market boundaries in day-to-day investment activities. The realityof these seminal developments are nowalmost universally recognized and ac-cepted, but their effects and implicationsare still being studied and assimilated.

A vital ingredient in the portfoliomanagement process is the estab-lishment of investment policy. That theelements of investment policy (risk andreturn objectives plus various con-straints) are so familiar to us as to betaken for granted is testament to the in-fluence that Managing Investment Portfo-lios, the textbook that formalized theportfolio management process for thefirst time, has had in the 15 years sinceits first publication.1 What may not beso clear is how investment policy mak-ing does or should reflect the now nearlytotal globalization of investment activi-ties. Given that the investment policystatement combines with capital marketexpectations to drive the asset allocationdecision, two particularly important re-sults of this globalization have been adramatic increase in the number,breadth, and sophistication of availableasset classes and the concurrent increasein the number and size of relevant capi-

lSee John 1. Maginn and Donald 1. Tuttle (eds.),Managing Investment Portfolios: A Dynamic Process,1985-1986 Update (Boston, Mass.: Warren, Gorham& Lamont, 1985).

tal markets. The interface and reciprocalinfluences between the United Statesand Japanese markets are of particularinterest because of the size and domi-nance of those two markets and the possi-bility that their evolution may augur theshape ofother markets that are now in theearly stages of development.

This proceedings, the product of aseminar jointly sponsored by AIMR andthe Security Analysts Association of Ja-pan, offers a fresh look from several in-stitutional and cross-border perspectivesat the investment policy process. Al-though the presentations address suchdiverse topics as the applicability of totalquality management, the importance ofclear client-manager communications,and the funding status of Japanese pen-sion funds, a singular common theme isthat the importance of articulating andimplementing thoughtful investmentpolicy cannot be overstated. That pro-cess enables both clients and managersto keep their focus in an increasinglycomplex global setting where rapidchange seems to be the only constant.

Policy and ChallengesIf investment policy is to be clearly setand closely followed, investment man-agers and their clients need to commu-nicate certain information and under-standing to each other. Charles Ellis dis-cusses this need in terms of the client'sagenda, the challenges facing invest-ment professionals, and the importantfactors in setting and implementing in-vestment policy.

Ellis suggests that, in meetings withinvestment managers, clients can ask aseries of questions that will focus on theagenda of great long-term interest to theclients themselves rather than on the

1

agenda that may be of current interest tothe investment managers. The ques-tions are: How do you conceive of andmake productive use of time? How doyou use risk and riskiness productively?How do you conceive of and use infla-tion in managing investments? How doyou define investment opportunity?

The challenges facing investmentprofessionals are categorized by Ellis asartificial, unreal, or real. Artificial chal-lenges are those, such as governmentregulation, that do not arise from clientneeds, manager capabilities, or marketforces. Unreal challenges are those thatcannotbe met successfully in the long run,such as timing the market or beating themarket rate of return. Real challenges, incontrast, are those with substantive long-term implications for clients, such asknowing the goals of specific funds andknowing the characteristics of specific in-vestments. The process of setting long-term investment guidelines must recog-nize specific fund situations and dependson clear communications between clientand manager.

With respect to policy implementa-tion, Ellis points out some dangers in tra-ditional performance measurement andemphasizes the specific responsibilities ofthe investment manager in carrying outpolicy mandates. He concludes with achallenge to investment professionals tounderstand themselves, the activity of in-vesting, and the lessons of history.

Policies and Practices of NorthAmerican Institutional Investors

To set the stage for a discussion of simi-larities and differences in the setting andimplementing of investment policy inJapan and the United States, threeauthors address the major concerns oflarge North American institutional in-vestors-insurance companies, endow-ment plans, and pension funds.

Life Insurance CompaniesEconomic, sociological, and regula-

tory changes have fueled a revolution inthe management of insurance companies'investment portfolios. John Maginn dis-

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cusses how the changes have affectedthe investment policies and practices ofU.S. life insurance companies and com-pares the life companies' policies andpractices with those of U.S. property andcasualty (P&C) companies.

Three trends have shaped the cur-rent investment policies and practices ofu.s. life insurance companies: short-ened liabilities brought on by the gen-eral economic turbulence of the 1970sand 1980s, the proliferation of two-income families, and an increase in theindustry's tax burden and regulatoryconstraints. As a result, the companies'policies and practices, although theymay be strikingly different from onecompany to another, are all now primar-ily liability driven and are shaped by thetypes of products sold by a company, itslevel of competition, and the degree ofregulatory and rating agency scrutinyunder which it operates.

Maginn highlights dramatic andcontinuing changes in return require-ments and specified risk tolerances. Thefocus of return requirements is on earn-ing a competitive return on the assetsused to fund liabilities by using suchapproaches as spread management andmanagement of total return. Risk man-agement objectives involve achievingcontrollable and acceptable levels ofcredit, interest rate, and currency risks.Maginn describes a core/satellite ap-proach that is often used to bring returnand risk objectives into sharp focus.

The investment policies of U.S. lifeinsurance companies are constrained bylimits on the scope of their investments;particularly important are liquidity,regulatory, and tax constraints. At-tempting to deal with these constraintswhile achieving risk and return objec-tives has contributed to a dramaticchange in the asset mix chosen by theindustry; many U.S. life insurance com-panies are using such nontraditional as-set classes as foreign bonds and deriva-tive securities.

Maginn concludes by outlining keydifferences between the U.S. life and theP&C companies with respect to objec-tives, constraints, and asset mixes. Bothsegments, however, are experiencing

major changes, and Maginn believesthat the insurance industry will developsome of the most dearly defined invest-ment policies among all institutional in-vestors.

Endowment ManagementThe range of objectives for endow-

ment funds is broad, and investmentpolicy for such funds must resolve thetension between the needs for immedi-ate income and for a growing stream offuture income. David Swensen first de-fines the purposes of an endowmentfund. He then discusses establishing thefund's investment goals, articulating itsinvestment philosophy, and construct-ing a portfolio consistent with the goalsand philosophy. His description of theendowment management process atYale University is a valuable illustrationof the process.

Endowments exist to help the affili-ated institutions maintain operating inde-pendence, to provide operational stability,and to allow a margin of excellence inoperations. To achieve these purposes,endowment management must pursuetwo contradictory objectives: preservingthe purchasing power of assets throughtime and providing a substantial, stableflow of current income to the operatingbudget. Swensen argues that this contra-diction must be reflected in the endow-ment's long-term spending policy andmust be addressed explicitly by means ofan equity bias in the endowment's invest-ment philosophy.

Swensen illustrates in detail howportfolio construction must reflect therelative importance of the expected re-turn contribution of asset allocation,market timing, and security selection; inhis view, only asset allocation makes asustained and positive contribution tototal return. Swensen also argues thatpassive management is appropriate inhighly efficient markets, such as that foru.s. Treasury bonds, but that activemanagement is essential in inefficientmarkets, such as the venture-capitalarena.

In the investment management proc-ess for the endowment fund of Yale Uni-versity, U.S. equity is the core asset class

for return. Non-U.S. and private equityare added to the portfolio to enhancereturn, while significant holdings oflong-term U.S. bonds and real estateserve as diversifying assets.

Swensen notes that the primary ele-ments of the Yale endowment manage-ment process are the annual policy re-view and clear demarcation of the threetypes of investment decisions-policy,strategic, and tactical. He suggests thatsuch a process can assist any manager ofinstitutional assets in developing ra-tional portfolios.

Pension PlansPension plan investment policy and

implementation should reflect not onlya plan's objectives, constraints, prefer-ences, and market expectations but alsothe latest thinking about successfulmanagement processes and organiza-tion. Keith Ambachtsheer discussestypes of pension plan arrangements inNorth America, important pension fundmanagement decisions, and how thequality-management paradigm can beuseful in making those management de-cisions.

Ambachtsheer contrasts the history,growth, and characteristics of defined-benefit and defined-contribution pen-sion plans. The latter arrangement hasbeen growing rapidly since the mid-1980s, particularly in the private sectorand for medium-size and small employ-ers, but defined-benefit plan assets stilltotal nearly three times those of defined-contribution plans.

The quality-management concepthas moved beyond application in theindustrial sector to several service sec-tors. Ambachtsheer provides an inter-esting description of its applicability inthe financial services industry. Of par-ticular utility to pension fund managers,he contends, is the discipline impartedin addressing four basic questions: Whoare the customers? What do they want?How is the product or service delivered?What is the best path to continuous im-provement? The third question raisesparticularly important issues with re-spect to investment policy, fiduciary re-sponsibilities, cost-effectiveness, and

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performance measurement.Ambachtsheer concludes that in-

vestment policies in the North Americanpension fund industry are being deter-mined by managers struggling with thetrade-off between immunizing pensionassets and increasing long-term returnsto reduce funding costs. The emphasisin policy implementation is on the iden-tification, measurement, and monitoringof cost-effectiveness in portfolio man-agement processes.

u.s. and Japanese PensionPolicies

John Thomas addresses the issue ofwhether the U.s. approach to settingpension fund investment policy appliesin Japan. He summarizes the U.s. ap-proach, examines the nature of Japanesecapital markets and the opportunity setavailable to Japanese pension plans, andprovides a look at the financial status ofJapanese pension plans.

Interest in capital market theory andthe passage of the Employee RetirementIncome Security Act of 1974 have beenmajor forces for increased diversifica-tion of U.S. pension plan assets, includ-ing investment in a wide variety of spe-cialized asset classes and the employ-ment of investment managers with a va-riety of skills and styles. U.S. corpora-tions now consider their pension plansto be liabilities like any other financialliability; accordingly, asserts Thomas,investment policy should reflect the bestway to finance the economic liability.

The U.S approach may be helpfulfor Japanese policymakers if Japanesecapital markets function in ways similarto those of u.s. markets, especially withrespect to asset pricing. Thomas pro-vides detailed evidence to suggest thatthe U.S. and Japanese capital marketsprice assets in reasonably similar ways.Ranking asset classes by risk is similar inboth markets, the distributions of re-turns for asset classes are comparable,and correlations among asset classes, al-though lower in Japan, are similar.Thomas also examines the risk-returnopportunity set currently available to

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Japanese pension plans, exploring theefficient frontiers generated under a va-riety of constrained and unconstrainedscenarios.

Thomas concludes his discussion ofpension policy by comparing the cur-rent funding status of u.s. and Japaneseplans. He argues that Japanese pensionplans are apparently underfunded on aneconomic basis and that fiduciary re-sponsibility would dictate intensive ex-amination of the financial status of eachJapanese pension fund.

ATale of Two Pension FundsThis proceedings concludes with a casestudy that deals with two defined-bene-fit pension funds, one for a public corpo-ration and the other for a large stateretirement system. The chief invest-ment officers of each fund are preparingfor formal presentations to their boardsof directors regarding potential changesin strategic asset allocations. These twoprincipals discuss in detail the evolutionin investing of pension fund assets, char-acteristics of each of their plans, andtheir capital market and political expec-tations for the balance of the 1990s. Theymust analyze four different asset alloca-tion strategies for each of three eco-nomic scenarios. Extensions of the casecall for the investment officers to evalu-ate the effects of adding new assetclasses.

Throughout the case, readers maycompare these managers' situationswith those of Japanese pension planmanagers and consider which asset-mixstrategies might be feasible for Japanesepension plans. The case analysis pro-vides detailed discussion of the alterna-tive strategies and suggests appropriatecourses of action based on the twofunds' objectives and constraints.

The case and analysis illustrate viv-idly how investment policy should-infact, must-eombine with capital mar-ket expectations if an appropriate assetallocation strategy is to be formulated.More importantly, they reaffirm thecritical importance of the policy-makingprocess and the resulting investment

policy. All of the capital market data setforth in the case, no matter how accurateor timely, have little value if taken out ofthe context of setting investment policy.Similarly, the potential strategies out-lined, regardless of their sophisticationor detail, are impossible to evaluatewithout the guidance of investment pol-

icy. Thus, the two investment officers inthe case, and investment professionalseverywhere in our rapidly changing andborderless investment environment, arereminded that investment policy is atthe heart of any portfolio managementprocess that purports to serve the undi-vided interest of its clients.

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Investing Policy and ChallengesCharles D. Ellis, CFAManaging PartnerGreenwich Associates

Communication between investment managers and theirclients is vital to setting and implementing sound investmentpolicies. The quality of communication is enhanced by afocus on the client's agenda and an identification of the realchallenges facing investment professionals.

Investment managers and their clientsneed to communicate certain informa-tion and understanding to each other ifinvestment policy is to be clearly set andclosely followed. This presentation be-gins with the client's agenda, proceedsto the unreal and real challenges facinginvestment professionals, and con-cludes with an outline of the importantfactors in setting and implementing in-vestment policy.

The Client's AgendaIn meetings with investment managers,clients can ask a series of questions thatwill focus on the agenda of great long-term interest to the clients themselvesrather than on the agenda that may be ofcurrent interest to the investment man-agers. The significant questions fromthe clients' perspective involve time,risk, inflation, and long-range invest-ment opportunities.

TimeClients should ask the investment

manager, "How do you conceive of andmake productive use of time?" Time isthe single most important force in in-vesting and the greatest power for goodor for ill. A manager who understands

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time's power will be able to respondwisely and usefully to this question.Many investment managers, however,will not understand why such a ques-tion about time is being asked.

In the United States, the principalproblem in investing is the manager's in-ability to use time productively and con-structively. Most investment managersspend their days striving diligently toknow what is happening at the momentin a fascinating but bewildering series oftransactions involving many different in-struments and markets. The compellinginterest of today, this hour, this minutekeeps their attention so focused on theimmediate present that they have diffi-culty reaching out to the longer horizonsthat make up "real" investment time forindividual investors. In investment man-agement, the short term tends to domi-nate the long term-the immediate andinsistent dominate the significant and en-during-because data, communicationsfrom others, and managers' own thoughtsand emotions are concentrated on theshort term.

Even executives responsible forpension plans or other long-term funds,who should be thinking in terms of 40years or 50 years because that is howlong the funds will remain invested,have difficulty thinking beyond fiveyears or ten years. People who are in

their 30s or 40s today are likely to liveinto their 80s. Their relevant investmenttime period is far longer than an hour ora day or a week.

The long term is where true invest-ment value will ultimately develop ornot develop. Particularly for pensionfunds and other institutional funds, thelong term defines the central purpose ofprofessional investment work.

Risk and RiskinessThe second question to ask an in-

vestment manager is, "How do you userisk and riskiness productively; how doyou make them work for you?" Overthe long term, higher rates of return areusually associated with increased riski-ness-that is, higher rates of perceivedrisk, or price variability. Tversky andKahneman have clarified the elementsof risk perception by studying the be-havior of human beings with regard totaking risk.1 One question in their studyasked individuals, "Will you take thisbet: If you toss a coin and it comes downheads, you win lS0; if it comes downtails, you lose 100?'' Most people areuncomfortable taking this bet, but manywill. The takers rightly estimate that itis a good bet for those sums of money. Ifthe terms are winning lSO,OOO versuslosing l00,000, however, almost no onewill take the bet. Even if they know theycan take that same bet a thousand timesin succession and, within the normaldistribution of odds and payouts, willthus stand to make money, almost everyindividual says, "No, I will not do that."The fear of loss is too important to mostpeople, including investment managers,to take that risk. We say we will takerisks, but as human beings, we are afraidof risk and will avoid it even when wewould profit by taking the risk.

The second powerful phenomenonTversky and Kahneman found was thefear of regret, or shame. Fear of havingto express regret or to apologize is apowerful restraining influence on the

lAmos Tversky and Daniel Kahneman,"Rational Choice and the Framing of Decisions,"Journal of Business, vol. 59, no. 4, part 2(1986):5251-78.

way most professional investment man-agers do their work. We do not want tobe in the position of apologizing, so weavoid risk. We avoid it too much.

The third discovery of Tversky andKahneman was an extraordinary capac-ity for human beings, including invest-ment managers, to exaggerate the im-portance of very unusual events withremote possibilities of occurrence. Theresearchers presented a large number ofpeople the following choice: an oppor-tunity to bet 300,000 and be a winner in2 percent of the cases or an opportunityto bet 600,000 and be a winner in 1percent of the cases. The choices areequal. The amount of winnings, afterdeducting the probability, is exactly thesame; technically, the first choice is"worth" 6,000 and so is the second. Inthe first case, the bettor has a 2 percentchance of winning (2 times out of 100,the bettor will win) and the payoff is300,000. In the second case, the bettorhas a 1 percent chance of winning600,000. The important point is that awin is very unlikely in either case. Nev-ertheless, the study found, people preferthe first choice, apparently because thesmaller payoff and proportionatelylarger probability seem less extremethan the alternative choice.

A fourth phenomenon, overreactionto recent information, is clearly true forinvestment managers. Investment man-agers know yesterday's events in such de-tail, have so much information aboutthese events, and are so impressed withthe speed with which the information wasprovided, that current information over-whelms other information. Managers arehard-pressed to remember what hap-pened a year ago. How about 10, 20, or 30years ago? We remember a lot about whathappened yesterday, a little less aboutwhathappened lastweek, and a good dealless about what happened a month ago;recollection of a year ago is dim and adecade ago is very dim.

The reality is that we are workingwith investments that will be part of theportfolio a day from now, a month fromnow, a year from now, even ten yearsfrom now. As the future unfolds, thoseinvestments will have been made a day

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ago, a month ago, a year ago, and so on.The investments may not be in the samesecurities, but they will be invested inessentially the same portfolios and will bethe investment manager's responsibility.What we invest in today and what we willhold in the future are connected, so weshould assess risk from a long-term, mul-tiperiod perspective. We should protectour assessments from short-term domina-tion and short-termconcerns about uncer-tainty and from our human tendency tostrive to avoid risk, and we should em-brace and exploit risk in long-term, well-diversified portfolios.

InflationA third question investors should

ask investment managers is, "How doyou conceive of and use inflation inmanaging investments?" The simpleRule of 72-the number of years timesthe rate of compound interest thatequals 72-allows managers to calcu-late quickly and easily the effect of infla-tion from the client's perspective. Thatis, if inflation is X percent, when willinvestors have exactly half as much pur-chasing power as today? How manyyears will such erosion take? Under theRule of 72, 3 percent inflation takes 24years (3 percent of 72 = 24 years) to cutpurchasing power in half. With 6 per-cent inflation, the 50 percent reductionarrives in 12 years. If3 percent inflationcan cut purchasing power in half in 24years, it can cut it to one quarter in 48years. In 48 years, investors who areyoung people at the beginning of theperiod will be elderly, and perhaps des-perately in need of financial support. Ifinflation is 6 percent, the problem is farmore severe: The investors will have1/16 of their present purchasing power.Clearly, the challenge for long-term in-vesting is to outgrow the cruel ravagesof inflation.

Long-Range InvestmentOpportunity

The investor also wants to know,"How do you define investment oppor-tunity, and how does the definition dif-fer by type of investment?" Equities are

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profoundly different from bonds. Andlong-term investments are extraordinar-ily different from short-term invest-ments. In the short run, equities are themore dangerous; in the long run, themore dangerous investments are bonds.

Challenges to InvestmentManagers

Investment professionals deal withthree types of challenges in addressingthe client's agenda. One type is artifi-cial, and a second type is unreal, but thethird type is very real.

Artificial ChallengesArtificial challenges are those that

do not arise from client needs, managercapabilities, or market forces. Regula-tion, whether direct governmental regu-lation or inappropriate regulation cre-ated by accounting requirements, is anartificial but severe challenge to long-term investment.

Of course, sound regulation can alsoplaya constructive role. Regulation candefend the innocent individual againstunfair exploitation by so-called expertsor insiders. In this role, regulation hasbeen positive.

In all countries, however, whenregulation has attempted to give explicitinstruction to honest experts rather thanrelying on their abilities to do their bestwork well, regulatory effectiveness hasbeen poor. One of the problems is thatregulatory authorities can easily misun-derstand the fundamental natures ofrisk, inflation, and investment. Thatmisunderstanding can result in forcefulrules that work great harm to the long-term purposes of individual investors.An example would be rules requiringpension funds to invest too much in debtsecurities and too little in equities.

The long-term policies that invest-ment managers and clients set for vari-ous portfolios reflect great national andcultural differences. International in-vestments are three-to-four times largerin British portfolios than in U.S. portfo-lios, for example, and Canadian pensionfunds are substantially less invested in

equities than U.S. or British pensionfunds (even though Canadian regula-tions are changing to allow more equityinvestment). Canadian pension fundsand Swiss pension funds, on the otherhand, have substantially greater invest-ments in real estate than U.S. pensionfunds. No real reasons underlie thesedifferences; the same markets exist forany large investor who can invest any-where in the world. Nevertheless, thedifferences persist. Investment man-agers should question this situation.

The largest challenge we will al-ways face in our profession is to assurethat governmental regulation is neverused to control basic thinking about in-vesting. The profession needs to playaconstructive role in regulation in everynation. Professionals have a responsi-bility to be sure that those who haveregulatory authority understand thefundamental truths about investing-particularly, investing over long periodsof time. Investment professionals needto reach out to regulators and help themunderstand the inappropriateness of us-ing short time periods, the importanceof understanding the power of inflation,and the significance of differencesamong investments.

Unreal ChallengesUnreal challenges are activities that

can absorb a fair amount of time and en-ergy but are not true challenges. Unrealchallenges include trying to beat the mar-ket rate ofreturn and market timing-get-ting into the market before it goes up, outof the market before it goes down, andback into the market before it goes upagain. One reason these activities are un-real is that, with large funds, they cannotbe done consistently with success. Whatmajor investment management organiza-tion has achieved a large net gain abovethe market return in any major market forany reasonable time through market tim-ing? Such activities are not only a wasteof time; they also distract investmentmanagers from work they might direct atreal challenges.

Real ChallengesThe real challenges to investment

managers are substantial. The first is toknow and understand the truly long-term goals of the particular funds undertheir care. How many of us can stateprecisely the long-term goals of the pen-sion funds, insurance funds, or endow-ment funds that we manage? Howmany of us could comfortably writesuch vital information down on paperand be proud to read it aloud to ourclients-or aloud to ourseives-IO or 20years from now?

Another real challenge is to knowthe fundamental characteristics of eachtype of investment, in terms of return,risk, and investment horizon-fromshort to medium to long term. Howmany of us know the optimal mix ofvarious types of securities for the long-term goals of each particular fund underour management?

We can easily identify the challengesin managing investments. The largerchallenge is managing ourselves and theother people that are joined with us inmanaging the investments. Investmentprofessionals need to be fearless at thosetimes when they might be afraid, andthey need to avoid overconfidence whenthings look good. They need to keeptaking the long-term view, even whenshort-term demands command their at-tention, and they need to manage them-selves to be totally rational at all times.

We investment professionals alsoneed to keep in mind that some whoparticipate in our investment decisionswill be younger and less experiencedthan we are; some, perhaps the mostinfluential, will be older and more pow-erful but may be far less experiencedwith investing. They may care greatlyabout the fund being discussed but maynot be expert in investing. We, as pro-fessionals, must manage their under-standing.

In managing those individuals' un-derstanding of investments and theiremotions at times of severe experi-ences-such as market highs or marketlows or during rapid drops or rises-two factors are paramount: the setting ofinvestment policy for the long term and

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the ability to adhere to investment pol-icy in the short term. One of the greatfootball coaches summarized his 40years of experience by saying, "It allboils down to planning the play andplaying the plan"-in other words, care-fully and thoughtfully deciding what todo and then being careful and certain todo what was previously decided.

Long-Term Policy GuidelinesThe process of setting long-term policyguidelines must recognize the signifi-cance of specific fund situations and theimportance of clear communications be-tween client and manager.

Specific Fund SituationsIn setting long-term policies, man-

agers and clients need to keep in mindthat fund situations differ enor-mously-in cash flows, available funds,levels of funding, and amounts of re-serve money available. Pension fundsexhibit the most striking differences.Enormous differences may exist amongcompanies in the average ages of em-ployees, but the pension portfoliosmeant to provide retirement benefits forthose employees may exhibit no corre-sponding differences. For example, alarge U.S. pension fund in a stable indus-try with almost no growth and in whichthe average worker age is nearly 50 mayhave a portfolio asset mix essentiallyidentical to the portfolio of a company inan industry that is growing very rapidlyand that anticipates continuously hiringnew people during the next 10, 20, or 30years. The first company will soon bepaying out large amounts of money incurrent benefits. The second company,in contrast, will be rapidly adding to itspension fund. In addition to this differ-ence in cash flows, the people's concernsare different. The old workers and theyoung workers are worried about en-tirely different things-the old aboutdeath and illness, the young about get-ting married and having and educatingchildren. That the pension funds re-sponding to the needs of those two dif-ferent groups of people should be so

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similar raises questions for all invest-ment professionals.

The United States has defined-bene-fit and defined-contribution funds, butthe defined-contribution funds aregrowing more rapidly than defined-benefit funds. Companies are saying toindividual employees, "You will be ableto control your own destiny. You will bein control of your investment." Someemployees know what to do and how todo it well, and some will be lucky andtheir investments will work out well.Many employees, however, will be dis-appointed by their investing becausethey are not prepared for the responsi-bilities of considering risk, time, and in-vestment opportunity and combiningthose considerations into a long-termportfolio.

For support for this prediction, con-sider what individual investors have thusfar done with their self-directed invest-ments. They have put their retirementmonies into savings plans rather than in-vestment plans. Most of the monies areinvested in very short-term investmentswhose principal characteristic is safety.These investors have not even begun tolook at the longer term.

Effective CommunicationsIn setting long-term policy for an

investment portfolio, the client and themanager need to communicate certaininformation to each other. The clientneeds to know the realistic expectationsfor each type of investment and eachasset class, for both the short term andthe long term and in the face of chaoticevents-those amazing things thatmight happen and then disappear intothe memory bank of time. What are therealistic expectations for risk, for vari-ation, and what is the long-term averagerate ofreturn?

The client needs to communicate theeconomic objectives of the fund for theshort, medium, and long term. Only theclient can bring such information to thejoint discussions with the manager thatwill result in investment policy.

Through communicating the neces-sary information, the manager and theclient together can and should resolve

investment policy. In most marketsaround the world, however, most of thedecisive work is done by investmentmanagers who are working alone andhave none of the vital knowledge of theclient. The clients come to the managersand say, "You know so much, you are sowise, you are so well informed, pleasetell us what we should do."

The best procedure would be for theclient to lead and control the process ofdiscovery and resolution of policy. Theclient must be responsible for decisionsbecause only the client knows the mostpowerful determinants of investmentpolicy in most organizations: the eco-nomic objectives of the fund and thenoneconomic constraints on the fund.The rest of the factors in the decision arefree information and are available in themarketplace.

Implementing the DecisionsThe manager's responsibility is not forleading the processes of discovery anddecision making; rather, it is for assuringthe implementation of the decisionsmade for playing the plan.

Performance MeasurementIn this regard, performance meas-

urement as it is usually defined is ofsurprisingly little value. Many lookupon performance measurement as ahighly useful tool and spend a lot of timediscussing and studying performancemeasurement data. In investment man-agement, however, useful performancemeasurement in the short run is impos-sible. We cannot do anything measur-ably useful today, this week, or thismonth; it is almost impossible to do any-thing useful this year or in the next twoor three years. The truly worthwhilethings that can be done in performancemeasurement will cover a 10- or 20-yearperiod.

Clients cannot wait that long, how-ever; they need to make swifter deci-sions. Therefore, clients are faced with adilemma: The data coming from the per-formance measurement tools are precisebut not necessarily accurate, intense but

not necessarily useful. Moreover, thedata either come too late to be used wellor, if "timely," are not sufficiently reli-able or accurate to be converted intouseful decisions.

By measuring and reading perform-ance reports and believing they havelearned something from the process, cli-ents may keep themselves from study-ing the meaning beyond the reports, thesubstance behind the data. The Greekphilosopher Plato described individualsin a dark cave with a small light tryingto understand reality by studying theshadows moving on the wall. Theirsituation is not unlike investing: Currentprices of securities are shadows of real-ity being imaged on the cave walls, notthe real business values. Are we lookingat the shadows on the wall and gettingvery precise information about whichshadow moves to the left, which to theright, which shadow is darkest, which islightest, which gains in size, which oneseems to get smaller, and not gaining anunderstanding of what is behind theshadows?

The misleading "precision" of per-formance measurement data shows upmost clearly in one extraordinary char-acteristic of the U.S. industry, namely, avery high rate of hiring and firing ofinvestment managers. The typical U.S.pension fund will hire one or more in-vestment managers every other year,and performance measurement is al-most always the justification given inthese decisions. Although a fund willhave several managers (not just one),changing one or more every two or threeyears is unwise and inappropriate.

Moreover, the manager terminatedbecause of performance data typicallyoutperforms the investment managerwho is brought in. Thus, the process ofchanging investment managers imposesa cost on pension funds every year.Those in charge pay little mind, how-ever, because the data clearly say, "Forthe past three years, this manager hasfailed, and for the past three years, thisother manager has done very well." Thedecision makers might be better off ifthey looked behind the data, treating thedata as shadows, and examined what is

11

causing the performance to be differentand learned what is temporary andlikely to be reversed versus what is en-during and warrants action.

Some friends of mine in New Yorkhave an approximately $200 millionfund with one of the highest rates ofreturn of any endowed fund of similarsize in the United States. Their annualinvestment committee meeting takesabout an hour, during lunch, and fo-cuses on a specific decision rule aboutmanagers. First, any manager who hashad a very good rate of return and isdoing the best she or he has ever done isfired. The committee sends a letter stat-ing, "As you know, when you came to usas a manager, we told you that if youever had a wonderful period where youhad the highest rate of return, youwould be fired. Today is the day. Con-gratulations on the wonderful returnyou have had, but you are fired."

The committee members then askeach other about managers who havehad apparently poor investment per-formance, as measured by the conven-tional performance measurement serv-ices, for the past three or four years.They prepare a list of these managersand study the list to discover whichmanagers have done their investingwisely and with disciplined commit-ment to their long-term professionalconvictions and commitments but hap-pen to have had "poor performance"according to conventional measures ofrecent results. The committee sendssuch managers a letter: "We understandyou have had disappointing apparentperformance for the past year or so.Please be of good cheer because we havestudied your actual investing beliefs andprocess, and we believe that the markethas not justly rewarded your approachfor the last year or so butwill reward youover the longer term. We know yourexperience. We know you have lost cli-ents. Today you are receiving a verysubstantial amount of money from us,and we trust your management. We arenot making a mistake, and we are notfools. We have deliberately chosen toput our funds in your care because webelieve you have great long-term capa-

12

bility as an investing professional. Ouraccount comes to you now when youmost want it. In candor, we advise younow that this account will be taken awayfrom you when you least expect it-when your conventionally measuredperformance looks good. We alwaystake the money away from a managerwho has had outstanding apparent per-formance for the past few years. Whenyou have outstanding performance,please be prepared: We will take ourmoney back."

Every year, people ask how it canpossibly manage this way, but the fund'sperformance over a 20-year period indi-cates that it has done just fine with itsselection of managers by choosing thosewho were capable for the long term butwere out of alignment with the currentgods of the market. The same sort ofthinking would have led U.S. long-termclients to move into stocks in the early1970s but out of growth stocks in 1970,out of real estate in the late 1980s, andout of value stocks in 1990.

Key Roles in ImplementationWhen investment policies are being

implemented, certain client and man-ager executives play key roles. They donot all have the same purposes and willnot behave the same, but each has animportant role. Investment profession-als who understand those roles have abetter chance of managing the total im-plementation process wisely.

First, the staff for any large fund hasclear responsibilities (although those re-sponsibilities may not always be madeclear to them by their own organiza-tions). These responsibilities are to clar-ify the issues, to provide clear alterna-tives to every decision being broughtbefore the decision-making board orcommittee, and to assure that the invest-ment managers follow the establishedpolicy of the fund in the particular port-folio that they manage and that all theiractions conform to agreed upon policyand long-term plans.

The senior committee has two re-sponsibilities: the formation of policy forthe very longest term and the final deci-sions about hiring or terminating any

manager who is unwilling or unable tofollow that investment policy.

The investment manager's respon-sibility is to execute exactly what hasbeen planned and is required and toadvise the plan sponsor of the conform-ance of the portfolio with the intendedpolicy. The investment manager mayalso be responsible for advising the sen-ior people in the fund about how theymight revise investment policy as thebroad characters of markets change.

Closing CommentsThe most important thing that we can doin investing is to understand ourselves.The second most important thing is tounderstand investing, particularly theextraordinary power of time. Finally,we can learn from what has gone before.

The philosopher George Santayana,when summarizing his life's learning,said, "Those who cannot remember thepast are condemned to repeat it." In-

vestment professionals have a wonderfulopportunity to study and learn from his-tory. To say that there is nothing newunder the sun is not far wrong. Almosteverything we can do in modern capitalmarkets could be done 400 years ago in anexchange conducted in Amsterdam; theyhad calls, puts, calls on calls, and puts onputs. The range of investment freedomwas wonderfully wide, and it enabledmany people to lose large amounts ofmoney.

The best and cheapest lessons arethose you can learn from someone else'smistakes; you do not have to make themistakes yourself in order to begin thelearning. If you have not made it part ofyour own life's work to study the historyof investment, begin the study now. Asprofessionals, we have for one of ourhighest purposes to learn how to learnfrom history so that we do not need tolearn the same lessons again and againat our clients' expense.

13

Question and Answer SessionCharles D. Ellis, CFA

Question: A fund may have differentmanagers using many different invest-ment styles, but it is seeking consistentsuccessful performance over the longrun in terms of investment philosophyand investment policy; for that pur-pose, what are the qualities or attrib-utes required of its managers?

Ellis: You correctly emphasized con-sistent performance. Any organizationthat strives to achieve consistent per-formance will have a philosophy of in-vesting that dearly defines the purposethat organization has in mind for itself.

Anyone type of investment typi-cally involves a profound under-standing of the investment market, andwith that understanding comes theawareness of at least one way of work-ing in that market that will succeed inthe long run. In common stock invest-ing, for example, people tend to beeither growth investors or value inves-tors. Both must have a guiding light,some fundamental long-term under-standing of the nature of the investment.This understanding, in turn, leads the in-vesting organization to do certain thingswell that will either reduce a problem orincrease an opportunity so that, in thelong term, the manager will achieve asuperior result for the client. Stayingwith that understanding consistentlythrough time is much more importantthan the specific style of the invest-ment-growth or value.

If you want to achieve successwith a consistent idea or set of beliefs,you need to have a consistent processby which you do your work. For ex-ample, each of us and our families hasa concept of "a happy family life," andeach family has a process for achievingit. Most of us realize that the proc-

14

esses are different for different fami-lies only when we marry and start toget acquainted with another process.

The situation is similar for achiev-ing investment goals; the process andpeople must be in harmony with thegoals, but the process may be differentfor a different "family," If you are goingto be a successful investor in growth,you need to understand why thatgrowth will develop and you need peo-ple who are skilled at understandingwhich companies do and do not havethe requisite characteristics. A value in-vestor needs individuals who are skilledat understanding the driving realities ofvalue investing. To combine the invest-ment vision, or long-term governingconcept, with day-to-day work requiresa process that is as consistent as the ideais consistently held. The process also re-quires individuals and groups of peoplewho have a set of values and a way ofworking together that allow them to beeffective in using the process to achievethe dream. They need to work always asa group of people who are deeply andconsistently attracted to the work they doand to working with, and challenging,one another. Out of that trust, they movetoward a common purpose in a commonprocess. And they care deeply about de-veloping and mastering the process theywill follow to achieve the type of invest-ing in which they believe.

The goal for the group and processis a "dynamic harmony" among the in-vestment goals, investment process, andinvestment people. Then you have theopportunity to achieve consistent per-formance. Neither "perfect harmony"nor disharmony is desirable. If you haveperfect harmony rather than dynamicharmony, you may have already com-pleted the best work and may be on

the way down. In an investment man-agement organization, therefore, lookfor individuals who have different, butnot profoundly different, beliefs. Agroup that admires differences anddraws out the person with slightly dif-ferent ideas, improves that person'sideas, and recognizes that they canlearn together to improve their processand achieve their purpose. Be wary ofan organization where the individualwith a somewhat different approach isnot wanted or an organization wherethe key people are frequently at oddswith each other.

Question: How do you define profes-sional ethics and professional moralsfor an investment professional?

Ellis: When discussing professionalethics, the focus, unfortunately, tendsto be on things that are absolutely for-bidden, must not be done, are obvi-ously wrong, and so on. The discus-sions typically deal with breakingrules established by regulatory authori-ties, usually misbehavior but extend-ing even to crime.

That focus does not truly dealwith professional ethics. Of course,we should not do inappropriate or ille-gal things, but professional ethics re-quire us to be sure that, over time, weare clearly holding ourselves to ahigher level of accountability thanmere legality and that we positivelypromote ethics. The ethical profes-sional not only avoids doing what iswrong, a simple commitment, but also

does the something extra that is right.Doing that something extra is not sim-ple or easy; it can be expensive andfrustrating, and we may never knowfor certain whether we did the trulyright thing.

Ethics in our profession involves acommitment to raising standards ofperformance through teaching andhelping young people achieve highprofessional standards, master theskills of the trade and use them alwaysin the service of clients, and take re-sponsibility for always keeping inmind the consequences of our workfor our ultimate clients-for example,the individual beneficiaries of pensionfunds. We should be saying to our-selves, "I am going to think about thepeople I have never met, people I willnever know, who have entrusted theirfunds to me and to my group. I wantto think about what we might do thatwe will be glad about later. Knowingthat those individuals will never cometo our office and will never ask us diffi-cult questions about what we are do-ing, never even ask us whether we ful-filled their hopes in the work that wedid, I want to think about what we cando that we would be proud to havedone if they were to ask."

The true ethical question is not"What did you do that was notwrong?" but "What did you do thatwas truly right?" Ethical behavior isdoing something you are proud of,even if it did not serve your own pri-vate interest. That behavior is what en-ables us to be true professionals.

15

Investment Policies and Practicesof U.S. Life Insurance CompaniesJohn L. Maginn, CFASenior Executive Vice President, Chief Investment Officer,

and TreasurerMutual of Omaha Insurance Company

Economic, sociological, and regulatory changes are influenc-ing the investment policies and practices of u.s. insurancecompanies. Investment policies reflect dramatic changes inreturn requirements and risk tolerances, and investmentprofessionals must deal with an array of challenging andevolving constraints.

A revolution has taken place in themanagement of insurance company in-vestment portfolios as a result of eco-nomic, sociological, and regulatorychanges. This presentation will discusshow the changes have affected the in-vestment policies and practices of U.S.life insurance companies and brieflycompare the policies and practices of thelife insurance companies with those ofU.S. property and casualty companies.

Important IndUstry TrendsThree forces have played key roles inshaping the current investment policiesand practices of U.S. life insurance com-panies. First, the inflation, high interestrates, and general turbulence of the U.s.economy during the 1970s and 1980sshortened the liabilities of most U.S. lifeinsurance companies. As policyholdersexercised their surrender options andpolicy loan privileges, insurance com-pany investment managers had to aban-don their traditional long-term invest-ment objectives, which emphasized

16

bonds and mortgage loans maturing in20-30 years, and shorten the duration oftheir portfolios, or at least of those seg-ments designed to fund interest-sensi-tive liabilities.

Second, two-income families haveproliferated during the past two dec-ades, and that trend appears to be wellestablished. According to a 1990 esti-mate by the U.S. Department of Labor,both the husband and wife were em-ployed on a full- or part-time basis inmore than 60 percent of U.S. house-holds. This change in income patternsreduced the need to purchase life insur-ance as protection against the prematuredeath of the primary or sole wage earnerin a household.

Third, for many decades, the regula-tion (by the states) and taxation (by thefederal government) of the insurance in-dustry in the United States was consis-tent and relatively benign. Since themid-1980s, however, tax rules and, mostrecently, regulatory restraints havechanged at a rapid rate. The results area substantial increase in the industry'stax burden and an evolving maze ofregulatory constraints that place rela-

tively tight restrictions on the invest-ment activities and flexibility of U.S. in-surance companies.

The confluence of these changes isreflected in the investment policies andpractices of U.S. insurance companies,particularly life insurance companies.Whereas 20 or 30 years ago, the invest-ment activities of various U.S. life insur-ance companies were strikingly similar,today the differences in investment poli-cies among companies are striking-areflection primarily of differences intypes of products sold and the charac-teristics of companies' policyholders. Inother words, the current investmentpolicies and practices of U.S. life compa-nies are first and foremost liability drivenand only secondarily shaped by capitalmarket considerations.

Factors Detennining InvestmentPolicies and Practices

The changes in U.S. life insurance compa-nies' policies and practices can be demon-stratedbyexamining how the policies andpractices are determined. Three forcesplaya primary role in shaping the invest-ment policies of U.S. life companies: thetypes of products sold, the level ofcompe-tition, and the degree of regulatory andrating-agency scrutiny.

Types of Products SoldProducts sold by U.s. life insurance

companies can be classified into threebasic categories:

protection products, the tradi-tional whole life and term insur-ance products;

protection/savings products, whichinclude universal life and the vari-able life insurance products thathave been introduced in theUnited States during the past 15years; and

savings products, both fixed andvariable annuities.

As shown in Table 1, the growth insavings products has completelyreshaped the composition of U.S. life in-surance companies' policy reserves. In

Table 1. Policy Reserves of U.S. LifeInsurance Companies

Year Life Annuity Other

1970 68.8% 26.6% 4.6%1980 50.7 45.4 3.91990 29.1 67.3 3.61992 28.5 67.5 4.0

Source: American Council of Life Insurance.

1970, life insurance reserves were morethan 68 percent of total reserves; by 1992,annuity reserves were nearly 68 percentof total reserves. So, a complete reposi-tioning of protection versus savingsproducts has occurred in the U.S. lifeinsurance industry in two decades.

This shift in emphasis can be attrib-uted to such socioeconomic factors as theincrease in two-income families, im-proved pension benefits, the general levelof affluence, and increasing longevity.Prior to and throughout much of the1970s, Americans were concerned aboutpremature death and sought protectionprimarily for lost income in such an event;during the past 15-20 years, the concernhas shifted to a fear of outliving financialresources.

Level of CompetitionThe competitive landscape for U.S.

life companies has been extended to in-clude other industries and mutual funds,which offer savings-type products to thepublic. Interindustry competition has be-come a major factor as changes in bankregulations have enabled banks to offerlife and annuity products. Banks havebecome aggressive sellers of annuityproducts and, in some cases, of full linesof life insurance products. In fact, the lifeinsurance industry faces its greatest com-petitive pressures from outside the indus-try. Some observers expect that, within afew years, banks will be allowed to ownlife insurance companies, thereby under-writing insurance risk. The U.S. Congressis discussing redefinition of the scope ofthe banking industry and the removal ofinterstate restrictions on banks. In effect,traditional distinctions among varioustypes of financial institutions are steadilybeing blurred by changes in regulationand by market factors.

17

Regulatory and Rating SCrutinyA very recent and important factor

shaping the investment policies of lifeinsurance companies is the degree ofscrutiny being applied by regulatoryand rating agencies. In the UnitedStates, insurance companies are regu-lated by the insurance departments ofthe 50 states. Those departments aremembers of the National Association ofInsurance Commissioners (NAIC),which is the central and coordinatinggoverning body for the U.S. insuranceindustry Because of the well-publicizedproblems surrounding the junk-bondinvestments (bonds with quality ratingsBor below) of companies such as Execu-tive Life Insurance Company, regulatoryagencies have been under considerablepressure to tighten restrictions on insur-ance company investments to preventcompany failures.

Regulations have been tightened forsecurities, mortgage loans, and real es-tate investments. The focus of regula-tion in the securities area was initially onjunk bonds, which are usually associ-ated with leveraged buyouts, but regu-latory concerns have not been limited tojunk bonds or even securities. In the late1980s, a major U.S. life insurance com-pany, Mutual Benefit Life InsuranceCompany, experienced severe and even-tually debilitating financial problems asa result of an overconcentration in realestate investments at the time of the bearmarket in U.S. real estate. The lack ofliquidity in real-estate-type investmentscontributed to the cash flow problems ofMutual Benefit and its eventual take-over by the New Jersey Insurance De-partment. In 1993, regulators and ratingagencies raised concerns about the con-centration of investments in mortgage-backed securities and the use of deriva-tives by U.S. insurance companies.

In the mid-1980s, the financial rat-ing services, such as Moody's, Standard& Poor's, and Duff & Phelps, began rat-ing life insurance companies and, even-tually, property and casualty compa-nies. These agencies also were embar-rassed by the failures of Executive Lifeand Mutual Benefit. In both cases, oneor more of the rating agencies had failed

18

to adjust their ratings quickly enough toreflect fully the deterioration in the com-panies' abilities to pay claims and thecompanies' declining financial solvencySubsequently, the rating agencies movedto the forefront of increased scrutiny of lifeinsurancecompanie~speciallytheir in-vestment policies and practices.

Investment ObjectivesThe investment objectives of U.S. life in-surance companies can be described interms of return requirements and risk tol-erance. As a result of the combined influ-ence of new products, intensified compe-tition, and increased watchdog activity,the investmentpolicies and practices havebeen modified and are being more rigor-ously defined than in the past. Returnrequirements and specified risk toler-ances have changed dramatically and arecontinuing to change.

Return RequirementsThe focus of return requirements is

on earning a competitive return on theassets used to fund liabilities, but severaldifferent approaches are taken to earn-ing such competitive returns.

Spread management. Life insur-ance companies have long been consid-ered spread managers, in that they man-age the difference between the returnearned on investments and the returncredited to policy or annuity holders.Spread managers focus on the yield pro-vided by fixed-income assets (bondsand mortgage loans) relative to the ratethat must be credited to policy/ annuityholders to be competitive and earn asatisfactory profit margin.

Most companies set crediting rateson either a weekly or monthly basis toreflect yields available in the market atthat time. In determining the basis forcrediting interest rates, U.S. life insur-ance companies use one of two methods.The investment-year method credits in-terest rates to policyholders on the basisof the yields on investments madewithin a particular calendar or fiscalyear. For example, all products sold

during 1993 would be credited interestbased on yields on investments madeduring 1993. In contrast, the portfoliomethod credits interest rates on the basisof the average yield on an entire portfo-lio of investments, regardless of whatyear those investments were made.

In periods of declining interest rates,companies crediting by the portfoliomethod will typically have the opportu-nity to provide higher crediting rates topolicyholders than companies using theinvestment-year method because of thelag effect of a multiyear average. Con-versely, in periods of rising interest rates,companies crediting by the portfoliomethod will find their crediting rates lag-ging behind the companies using the in-vestment-year approach.

Much time and attention is given tothe management of spread by invest-ment, actuarial, and marketing staffs ofU.S. life insurance companies, becausespread management has critical implica-tions for the attainment of profit objec-tives and the maintenance of asset/li-ability management. The temptation tomismatch (by extending the duration ofassets well beyond the duration of li-abilities) to earn a wider spread in-creases the interest-rate-risk exposure ofa life company.

Total-return management. Duringthe 1980s, the concept of total return,which has long been well accepted in pen-sion and endowment fund management,began to gain acceptance in the life insur-ance industry. Because of the bull marketin bonds that existed during most of thedecade and into the early 1990s, some lifeinsurance investment managers shiftedtheir attention to managing total return.

In that methodology, managers mea-sure the interest earned plus the changein market value of fixed-income assetsas being the return on which to base thecrediting of earnings on life insurancepolicies or annuity products. The focusof attention is on managing the spreadbetween the expected total return on ac-tively managed bond portfolios and thecrediting rates on companies' interest-sensitive products.

These differences in approaches andtechniques used by U.S. life insurancecompanies to manage their investmentportfolios and to credit earnings rates ontheir products are reflected in some ofthe differences in the overall portfolioyields of u.s. life insurance companies,as illustrated in Table 2. In periods ofdeclining interest rates, the averageyield on a total-return portfolio can beexpected to decline more rapidly thanthe yield on a spread-managed portfo-lio. This phenomenon reflects the trad-ing activity, and thus portfolio turnover,characteristic of a total-return portfolioand the desire to capture realized gainsfrom the periodic, if not continuous, saleof bonds in the portfolio.

Return requirements for surplus.The prevailing literature on life insurancecompany investments is relatively scantand devotes little attention to the invest-ment of surplus funds. Life insurancecompanies' return requirements do in-clude as an objective, however, the earn-ing of competitive returns on assets thatfund surplus.

Surplus in the insurance industry isextremely important, both as an indicatorof financial stability and as a basis for

Table 2. Portfolio Yields of U.S. Life Insurance CompaniesMajor Life Companies

Industry Lincoln Equitable-Average Prudential National New York

Year Yield Life Life Life

1970 5.34% 5.56% 5.47% 5.32%1980 8.06 7.85 8.09 8.181990 9.31 8.80 8.68 7.261992 8.58 8.31 8.54 7.50

Sources: A.M. Best & Co. and the American Council of Life Insurance.

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expansion of the business. Thus,growth in surplus, through operationsand investments, is an important mea-sure in the industry.

When selecting investments forsurplus funds, investment managershave typically sought out assets thatprovide the potential for capital appre-ciation, such as common stocks, real es-tate, and to a lesser extent, venture capi-tal. Common stock returns are meas-ured on the basis of annual total returnsrelative, generally, to some market in-dex, such as the S&P 500. For real estateinvestments, the internal rate of returnduring a holding period of as much as10-20 years is used as a measure of re-turn potential. Similarly, for venture-capital investing, the internal rate of re-turn, generally for an intermediateholding period of 8-10 years, is used asa return measure.

Risk ToleranceConfidence in the ability of an insur-

ance company to pay benefits as theycome due is a crucial element in thefinancial foundation of the U.S. econ-omy. Thus, insurance companies aresensitive to the risk of any significantchance of principal loss or any signifi-cant interruption of investment income.The risk-management objective of U.S.life insurance companies can be definedas achieving controllable and acceptablelevels of three types of risk: credit, inter-est rate, and currency.

Credit risk. lifeinsurancecompa-nies attempt to achieve a controllable levelof credit risk through internal limits oncredit quality. Bonds rated Baa/BBB orbetter are considered to be investmentgrade. Some companies have no self-im-posed limits onholdings thatfall within theinvestment-grade classification; other,more conservative, companies limit thepercentage of holdings, especially inBaa/BBB-rated securities. Many compa-nies purchase bonds rated below Baa/BBBon an exception basis; that is, such invest-ments require prior approval by an invest-ment committee and/or mustbe limited inthe amount invested (as a percentage ofassets or absolute dollar amount) and/or

20

scope (the lowest credit rating permit-ted, for example, might be a single B).

The NAIC inaugurated a credit-riskclassification system for insurance com-pany bond holdings in 1992. The systemuses six classifications of credit risk. Ta-ble 3 shows the relationship between theNAIC classifications and the financialratings of Moody's for various types ofbonds. The table also shows the hold-ings of U.s. life insurance companybonds by NAIC classification at year-end 1992. The insurance industry at thattime had limited exposure to non-investment-grade bonds; investment-grade bonds accounted for 92.6 percentof total bond holdings and 59.1 percentof total assets.

Table 3. Bonds Held by U.S. LifeInsurance Companies byQuality Class, December 31,1992

ComparableMoody's Percent of Total

NAICClass Rating Bonds Assets

High quality1 Aaa,Aa,A 71.0% 45.3%2 Baa 21.6 13.8

Medium quality3 Ba 3.1 1.9

Low quality4 B 2.6 1.75 Caa,Ca,C 1.1 0.76 D

--l!& --.MTotal 100.0% 63.8%

Source: A.M. Best & Co.

Interest rate risk. Given the inter-est-sensitive nature of the majority ofmodem life insurance products, interestrate risk is dearly the most pervasive ofthe risks being managed by life insurancecompany investment professionals. Fi-nancial theory points out that interest raterisk is also difficult to anticipate andlargely nondiversifiable. These charac-teristics explain the time and attentionthat the U.S. life insurance industry de-votes to asset/liability management.

The purpose of asset/liability man-agement techniques is to align theinterest-rate-risk characteristics of assets

with those of liabilities in such a way thatboth sides of the insurance company'sbal-ance sheet are synchronized in relation tothe effects expected from changes in inter-est rates. To accomplish this synchroniza-tion, a life insurance company's actuariesdetermine, through cash flow testing andmodeling of interest rate scenarios, theexpected duration of liabilities. The goalis to simulate the optionality of theinterest-sensitive products being offeredby the company.

One option in such products is theoption to surrender a policy-typically,with penalties in the early years of apolicy or annuity's life and without pen-alties in the later years (for example, thesixth year and beyond). Another optioninvolves the policy loan privileges in-cluded in many traditional life insur-ance policies. Either of these options canbe triggered by changes in interest rates,and the resulting cash flow/liquidityneeds can occur at a time of decliningbond prices, which forces insurancecompanies to sell assets at a loss. As-set/liability management attempts tomitigate this risk of forced sale.

Because of the different option fea-tures in various types of life and annuityproducts, most U.s. life insurance com-panies segment their portfolios so as togroup liabilities by similar interest-rate-sensitivity characteristics. Investmentmanagers then attempt to constructportfolios by segment so that the mostappropriate and attractive assets, bothby type and duration, are being used tofund the various product segments. Byaligning the duration of assets and theduration of liabilities, the managers canmeasure, monitor, and manage degreesof interest rate risk.

Table 4 illustrates asset/liabilitymanagement by way of an example ofhypothetical duration targets, credit-riskparameters, and product segments for aU.S. life company. In panel A, variousproduct segments are identified and ex-amples of asset/liability durations arelisted. The durations shown for liabilitiesare only representative in nature; differ-ences in product offerings ofvarious com-panies could result in rather broad rangesof liability durations. Panel A of Table 4

also reflects the policy of limiting inter-est rate risk by having relatively smalldifferences between the target durationsof liabilities and assets. Again, individ-ual companies can have widely varyingpolicies with regard to the allowable gapbetween asset and liability durations.Panel B of Table 4 is an example of howasset/liability management translatesinto portfolio specifications; such deci-sions as types of assets, ranges of matur-ity or average life, and credit quality areaddressed for those asset classesdeemed to be appropriate for funding aparticular product segment (in this case,traditional whole life).

Tolerance for interest rate risk, or forthe degree of duration mismatch, variesby company, but the sharp increase inU.S. interest rates starting in October1993 focused increased attention on in-terest rate risk (especially in mortgage-backed and derivative securities) fromregulators and rating agencies. Just astheir scrutiny has led to modificationand limitations on the credit risk takenby insurance companies, their scrutinymay lead to new limitations on the tak-ing of interest rate risks.

Currency risk. The insuranceregulations in most states limit life in-surance company holdings of foreign se-curities, whether denominated in U.s.dollars or foreign currency, to 5 percentof total assets. Thus, U.S. life insurancecompanies have only limited opportuni-ties to manage currency risk to achieveadditional return. To moderate cur-rency risk, most U.S. life companies thatinvest in foreign securities denominatedin foreign currencies diversify theirholdings by currency. Some also usehedging strategies to minimize furtheror neutralize the risk of exchange ratechanges. Most studies of foreign invest-ments indicate, however, that a signifi-cant part of the return advantage attrib-utable to foreign securities is associatedwith changes in exchange rates.

Financial literature also points outthe covariance benefits of using foreignsecurities in a portfolio to diversify in-terest rate and credit risks. Thus, as thetrend to globalization of capital markets

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Table 4. An Example of AssetlLiability Management Applied to a U.S. LifeInsurance Company

A. Duration by product segment

Duration (in years) of

Product Segment

Traditional whole lifeUniversal lifeSingle premium deferred annuityGuaranteed investment contract

B. Portfolio segment specifications

Traditional Whole Life

Corporate bondsPublic bondsPrivate-placement bonds

Mortgage-backed bondsMortgage loans

Source: John 1. Maginn.

Assets(actual)

5.04.23.92.5

Maturity or Average Life(years)

3-123-123-103-10

Liabilities(target)5.24.03.82.3

Quality

A-BaaA-BaaAaa

continues, one of the results could besome expansion of the ability of U.S. lifeinsurance companies to use foreign se-curities as return-enhancing and risk-diversifying assets.

Determining acceptable risk levels.As noted earlier, much regulatory andrating-agency time and attention is beinggiven to determining the acceptable levelof risk for U.S. life insurance companies.Traditionally, this attention has primarilyaddressed credit risk; investment laws inthe United States limit the percentage ofholdings by credit quality, especially forbonds rated below Baa/BBB, and by typeof asset (especially mortgage loans, com-mon stocks, and real estate). In addition,the NAlC inaugurated an asset valuationreserve (AVR) in 1992, which requires in-surance companies to set aside reservesbased on the risk characteristics of theirassets; the AVR can be thought of as abad-debt or credit-risk reserve.

In 1993, U.S. regulators introducedthe concept of risk-based capital for U.S.life insurance companies. These regula-tions require that a U.S. life insurancecompany maintain a level of capital andsurplus that is based on the risk charac-

22

teristics of that company's assets andliabilities. Prior to the advent of the con-cept of risk-based capital, most states setminimum dollar amounts of requiredcapital and surplus regardless of the na-ture of the company's assets and liabili-ties. Risk-based capital should prove tobe a much more accurate measure of riskexposure and risk tolerance than theprevious approach, and additional rulesrelated to risk-based capital will un-doubtedly be developed through appli-cation and experience.

Table 5 compares the risk factors forvarious asset classes as specified underthe risk-based capital (RBC) and AVRregulations; the difference in factors un-der the two types of regulation is clear.The AVR was established before the RBCrequirements were defined, and regula-tory agencies are attempting to syn-chronize the factors.

CorelSatellite ApproachTo bring their investment objectives

into focus, and to highlight the differencesin asset groupings used to fund liabilitiesand to fund surplus, many life insurancecompanies are using a core/satellite ap-proach for a broad definition of their in-

Table 5. Comparison of Risk Factors for RBC and AVR

BondsNAIC

Item Category RBC AVR

Bonds and preferredstock 1 0.3% 1.0%

2 1.0 2.03 4.0 5.04 9.0 10.05 20.0 20.06 30.0 20.0

Commercial mortgagesIn good standing90 days overdue

Real estateCompany occupiedInvestmentForeclosed

Source: Goldman, Sachs & Co."Adjusted for percentage of nonperforming assets.

UnaffiliatedPreferred Stock

RBC AVR

2.3% 3.0%3.0 4.06.0 7.0

11.0 12.022.0 22.030.0 22.0

3.0 3.56.0 3.5"

10.0 7.510.0 7.515.0 7.5

vestment policies. Figure 1 depicts fund-ing strategies for assets and liabilitieswithin risk-management parameters. Thelarge circle on the left side reflects the coreinvestments used to fund typical life insur-ance liabilities. The size and position of thecircle suggest that the vastmajority offund-ing assets for liabilities would be invest-ment-gradebonds or mortgage loans; com-bined, those assetswouldprovideanappro-

priate level of liquidity on thebasisofbothmaturity and cash flow: The smaller circlesoverlapping the top of the outer ring of thelarge circle depict the use of small but inten-sively managed portfolios of higher risk as-sets to enhance returns from the liability-funding portfolio. The small circles at thebottom within the dotted lines depict strate-gies to control risk. Common stocks and realestate are the logical core assets for funding

Figure 1. CorelSatellite Approach to Achieving Investment ObjectivesLiability Funding

Source: Mutual of Omaha Insurance Co.

//

//

//

/

Surplus

Common Stocks Real Estate

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surplus, with venture capital and otherhigher risk assets used in smaller propor-tions to enhance return and derivatives tocontrol risk.

In addition to providing insights intothe process ofsetting investmentpolicy, thecorelsatellite approachhas proved tobe aneffective way of communicating with in-vestment committees, boards of directors,rating agencies, and regulators.

Investment ConstraintsInvestment policies of U.S. life insurancecompanies are constrained by limits onthe scope of their investments. Of par-ticular importance are liquidity, regula-tory, and tax constraints.

LiquidityBecause life insurance and annuity

products are basically promises to payupon death or at some time in the future,a key investment constraint for the in-surance companies is a need for liquid-ity, for funding operational workingcapital and funding unexpected surren-der levels and/or policy loans. The liq-uidity position of insurance companiesis also of prime concern to regulatorsand rating agencies. Too often, U.S. lifeinsurance companies devote inadequateattention to liquidity needs.

Historically, liabilities of the compa-nies were relatively long term; therefore,current liquidity needs were relativelymodest. The volatility in interest ratesin the United States in the past two dec-ades, however, has materially shortenedthe duration of the liabilities of u.s. lifeinsurance companies and increasedtheir liquidity needs accordingly.

RegulationAs noted earlier, regulatory factors

are important constraints for U.S. life in-surance companies. In addition to the re-cent AVR and RBC requirements, regula-tors are also debating a new model invest-ment law that would define limits forholdings of certain types of assets.

The Financial Accounting Stand-ards Board has recently (Financial Ac-counting Statement No. 115) required

24

U.S. life insurance companies to marktheir bond portfolios to market. Thischange in accounting, which is in effectas of 1994 for stock life insurance com-panies in the United States, is an exam-ple of a well-intentioned but unbalancedapproach. Marking to market bond as-sets only, rather than all assets and allliabilities, will create major distortionsof the surplus positions of U.s. life insur-ance companies. In some cases, suchdistortions could lead to erroneous con-clusions about the financial stability of acompany Fortunately, discussions arecontinuing about broadening the mar-ket-value principle to apply to bothsides of the balance sheet and to all, or atleast most, asset classes.

TaxesAs if heightened liquidity needs and

increased regulatory constraints were notenough, the U.s. life insurance industryhas also shouldered a substantial tax bur-den through the tax on deferred acquisi-tion costs and other changes in income taxlaw that have accumulated since the mid-1980s. U.S. life insurance companies to-day commonly have effective federal in-come tax rates that can reach or exceed 50percent (as compared with the currentcorporate tax rate of 35 percent).

Asset-Mix ChangeA reflection of the scope of the changesin the U.s. life insurance industry in thepast 20 years is the change in asset mix,as shown in Table 6. The traditional listis types of investments favored by mostcompanies through the mid-1970s. Thecontemporary list is asset classes currentlyused by many, although not all, U.S. lifeinsurance companies. Clearly, recent capi-tal market changes, particularly the finan-cialengineeringonWallStreet,havebroad-ened the array of assets available to andbeing used by U.S. life insurance compa-nies to meet their investmentobjectivesandto deal with the constraints under whichthey operate.

Table 6. Changes in Life InsuranceIndustry's Asset Mix

Traditional Contemporary

Bonds, domestic Bonds(Aaa-Baa) Domestic

Aaa-Ba qualityJunk bonds

ForeignHedgedUnhedged

Mortgage loans, Mortgage loans,residential commercial and

residential

Stocks, common and Common stocks,preferred domestic and foreign

Equity real estate Equity real estate

Other, venture capital Venture capitalDerivative instruments

FuturesOptionsInterest rate swaps

u.s. Property and casualtyCompanies

The investment policies and practices ofU.S. property and casualty insurancecompanies are significantly differentfrom those of life insurance companiesbecause the liabilities, risk factors, andtax considerations are distinctly differ-ent. These differences are reflected inthe return requirements, risk tolerances,and investment constraints of U.S. prop-erty and casualty companies.

Investment ObjectivesThe investment objectives of U.S.

property and casualty companies aredesigned to fund liabilities that are ma-terially different from the liabilities ofthe life insurance companies. As theirname implies, property and casualtycoverages are designed to reimburse forphysical or monetary damages incurred.Therefore, no earnings rates are creditedon typical policies, and most propertyand casualty liabilities are not directlyinterest rate sensitive. These insurersdo, however, face greater uncertaintythan life insurance companies and, po-tentially, greater frequency of claims.

Return objectives. The return re-quirement for typical property andcasualty companies is to maximize theafter-tax yield on their fixed-income in-vestment portfolios. In addition, thesecompanies typically have much largercommon stock portfolios than do U.S.life insurance companies.

In recent years, U.s. property andcasualty companies have embarked onmore active management of their bondportfolios than in the past. The goal is toenhance the typical return contributionof the bond portfolio; a side benefit is theaugmentation of portfolio liquiditycharacteristics.

Property and casualty companiesuse common stocks not only to fundsurplus but also to fund some portion ofliabilities. Common stock investmentsin a property and casualty company'sportfolio are measured on a total-returnbasis, typically relative to a market in-dex such as the S&P 500.

Risk tolerance. Management ofinvestment risk is also a key factor for u.s.property and casualty companies. Thesecompanies attempt to identify an accept-able level of risk and demonstrate an abil-ity to control investment risk. The liquid-ity requirements of property and casualtyinsurers limit their risk tolerances and in-fluence their investment policies.

Investment ConstraintsThe exposure of property and casu-

alty companies to unpredictable andcatastrophic claims requires their invest-ment staffs to focus on the high liquidityand marketability of portfolio assets.These liquidity needs have created a dif-ferent regulatory attitude toward theproperty and casualty companies fromthe attitude toward life insurance com-panies. The companies' liquidity needsand this regulatory attitude are part ofthe reason common stocks have longbeen an acceptable asset holding for U.S.property and casualty companies.Whereas U.S. life insurance companiesare typically limited to no more than 10percent of assets in common stocks,property and casualty companies typi-cally maintain percentages of 20 percent

25

or more of their portfolios in stock.The differences in the regulatory ap-

proaches suggest that regulators recon-sider the role of common stocks in lifeinsurance investing. The narrowing dif-ference currently being experienced inthe U.S. markets between the volatilityof bond prices and that of stock pricesmay encourage such a reexamination.

Investment law as applied to prop-erty and casualty insurance companiesis far less restrictive than as applied tolife insurance companies. RBC and AVRrequirements will be applied to the U.s.property and casualty industry, how-ever, in the mid-1990s. These conceptsare new for this industry and are ex-pected to constrain the risks taken andrisk exposure of the typical property andcasualty company.

Although income taxes are a consid-eration in shaping investment policy forproperty and casualty insurers, their in-come taxes are not nearly as burden-some or restrictive as those of the lifeinsurance companies. The effective taxrates for property and casualty compa-nies are typically 35 percent or less.

Asset DistributionKey differences between U.S. prop-

erty and casualty and life insurancecompanies in asset mix and investmentpolicies can be identified by examiningtheir respective asset holdings. Table 7outlines the typical holdings of companiesinboth industries atyear-end 1992. Signifi-cant differences exist in the holdings ofcommonstocksandnon-investment-grade

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Table 7. Comparison of Asset MixesAdmitted Property/ Life/Assets Casualty Health

Cash and short-term 6% 3%assets

Stocks 11 2Bonds (investment

grade) .6Q 51Total liquid assets 77 56

Bonds (not investmentgrade) 0 3

Mortgage loans 0 14Real estate 0 3Affiliated companies 4 2Other assets

-.19. --.22Total assets 100% 100%

Source: A.M. Best & Co.

bonds, mortgage loans, and real estate.

ConclusionThe U.S. insurance industry, particu-larly the life insurance segment, is expe-riencing major changes. Multiple fac-tors are influencing the investment poli-cies and practices ofinsurance companies.Investment professionals are being chal-lenged to manage risk more adroitly thanin the past and meet much more rigorousregulatory and rating-agency require-ments. One result will be the evolutionwithin the insurance industry of some ofthe most clearly defined investment poli-cies among all institutional investors.

Question and Answer SessionJohn L. Maginn, CFA

Question: You suggested that lifecompanies should increase their stockinvestments, but can they do so underRBC requirements, which consider thestock ratio already too high?

Maginn: We are faced with a conflictbetween regulation and investmenttheory today; the conflict poses an edu-cational task for the industry. Thehope is that actuaries and, in tum,regulators can be convinced of severalfactors already known to investmentprofessionals.

First, common stocks are consid-ered riskier assets by regulators be-cause of the variability of their returnsand the traditional volatility in stockprices. Bond prices in the UnitedStates today, however, have as muchas or more volatility than stock prices.On a market-value basis, stocks arenot a riskier asset. Stock investmentswould take advantage of financial the-ory's conclusion that expected returnsare higher over long time periods forcommon stocks than for fixed-in