Time horizon of casualty companies (non-Life insurance)

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Section 4.2.4, p.353 of CFAI #2, or p.24 of Schweser #2.
Average maturity of nonlife company’s bond portfolio is LONGER than that of a life company because of the “predominance of long-term tax-exempt bonds held to maximize after-tax returns”.
Can sb explain more of this?
- sticky
 
I think they are talking about 2 different things here. You have the investment time horizon and bond maturity. We are talking about 2 different things here. Due to the timing and amount of claim for a non-life insurance company. The investment port. for that particular product segment’s time horizon is shorter compare to life insurance company (becuase the timing and claim can be known, or should I say timing can be better estimated). So the time investment horizon is longer for life-insurance company. The statement you have shown is correct because non-life insurance company has a shorter time horizon, they have to max. their return on the asset so they can generate enough return to pay the claim…therefore compare to a life-insurance company, you will see more longer term bond since they pay more.
I am not sure if I answered your question….but I hope this helps a little.
 
replies below.
ws Wrote:
——————————————————-
> I think they are talking about 2 different things
> here. You have the investment time horizon and
> bond maturity. We are talking about 2 different
> things here. Due to the timing and amount of
> claim for a non-life insurance company. The
> investment port. for that particular product
> segment’s time horizon is shorter compare to life
> insurance company (becuase the timing and claim
> can be known, or should I say timing can be better
> estimated). So the time investment horizon is
> longer for life-insurance company.
yes, I understand this from time horizon perspective.
> The statement
> you have shown is correct because non-life
> insurance company has a shorter time horizon, they
> have to max. their return on the asset so they can
> generate enough return to pay the
> claim…therefore compare to a life-insurance
> company, you will see more longer term bond since
> they pay more.
I am confused. If “getting more return from longer term bond” is the reason, then:
1. will there be duration mismatch? (since non-life company needs shorter duration portfolio)
2. why are insurance company do the same thing and get more longer term bond?
I also see your other reply regarding “the last sentence”. Yeah, I understand the yield is higher for longer bonds, but how can this be “optimized”, according to that last sentence?
- sticky
 
>
> 1. will there be duration mismatch? (since
> non-life company needs shorter duration
> portfolio)
>
> 2. why are insurance company do the same thing
> and get more longer term bond?
>
1. Unlike pension fund, the liability amount changes given market condition, non-life insurance company’s liability’s timing and amount is unknown! You are right, there will be a mis-match in duration, however, that is a less of a concern. For non-life insurance company, for that particular product segment, their goal is to max. their return so they can pay the claim at end of the underwriting cycle. I guess you can say “well, I don’t have much time, I need to get all the return I can get”.
2. I am assuming you are talking about life insurance company. Once again, amount for the claim is know, but timing can be better estimated. Therefore, an ALM approach can be used for life insurance company.
 
Agree with ws in this.
In CFA books, the issue is explained as more of a trade off.
So to reiterate, it is true that non-life insurance companies liabilities are shorter duration than life-insurance companies and they have to resort to some kind of ALM approach. However their ALM approach will be different than the life insurance companies. First the natura of their liabilities are different. Second the regulations they are subject to different. Furthermore the taxes facing non-life insurance companies for their investment income is different than non-life insurance companies.
They use longer term tax-exempt bonds to take advantage of more positively sloped yield curve for these types of bonds. They also use these bonds to manage their taxable income according to their underwriting loss or gain.
 
I haven’t read the CFAI text on this yet (or Schweser either) but I do know that property and casualty works like term insurance.
You buy auto insurance for a year. Then you renew. Again and again.
The liabilities are there for a year only. P&C companies set their rates so that the ratio of premiums to claims plus expenses is enough to generate profit. One year at a time.
In the background there is a capital reserve (required by law) and that’s what’s invested for the long term (and paid out in catastrophic scenarios). The probability of catastrophe is very low, but the payout is very high. I don’t think there’s liability matching, the way we would normally think of it. But that’s probably why they have longer maturities – they don’t have any measurable liability so they just invest for the highest after tax return!
 
TooOld4This Wrote
>they don’t have any
> measurable liability so they just invest for the
> highest after tax return!
Good word choice “measurable”! Since they don’t know…heck, let’s just shoot for the highest return.
 
Actually the word I probably should have used was “material”. It’s not that they don’t know, they know it’s a small expected value.
Funny, I missed your previous posts, ws, I see that you agree with me.
 
TooOld4This Wrote:
——————————————————-
> Actually the word I probably should have used was
> “material”. It’s not that they don’t know, they
> know it’s a small expected value.
>
> Funny, I missed your previous posts, ws, I see
> that you agree with me.
No, I still think “measurable” is a better choice than “material”, with a large insurance policy, the claim $$ can still be material. However, due to the nature of P&C insurance, they can’t MEASURE the timing and amount very well.
 
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