Historically, a life insurance company's return requirements have been specified primarily by the rates that actuaries use to determine policyholder reserves, that is, accumulation rates for the funds held by the company for future disbursement. In effect, the rate either continues as initially specified for the life of the contract or may change to reflect the company's actual investment experience, according to the contract terms. Interest is then credited to the reserve account at the specified rate; this rate can thus be defined as the minimum return requirement. If the insurer fails to earn the minimum return, its liabilities will increase by an accrual of interest that is greater than the increase in assets.

Life insurance companies. Return Objectives


The shortfall is reflected in a decrease in surplus or surplus reserves, assuming the simplest case. The insurer, in short, desires to earn a positive net interest spread, and return objectives may include a desired net interest spread. (The net interest spread is the difference between interest earned and interest credited to policyholders.) Reserve funding adequacy is monitored carefully by management, regulatory commissions, and insurance rating agencies such as A.M. Best, as well as through the claims paying rating services initiated by Moody's Investors Service, Standard & Poor's Corporation, and Fitch Ratings ( insurance mathematics ).

In the mid to late 1980s, Japanese life insurance companies issued policies that guaranteed what proved to be unsustainable reserve crediting rates—and guaranteed those rates for as long as 10 years. With the sharp decline in interest rates, stock prices, and real estate values during the 1990s in Japan, these companies sustained unprecedented losses and consequent erosion of the surplus of the Japanese life insurance industry. These events provided an important lesson regarding the setting of return objectives, crediting rates, and guarantee periods in a volatile investment environment.

In the United States, with whole-life insurance policies, the minimum statutory accumu­lation rate for most life insurance contracts ranges between 3 and 5.5 percent. Thus, in the higher interest rate environment of the 1970s and 1980s, the spread between life insurance companies' return on new investments and even the return on their entire portfolio exceeded the minimum returns by a widening margin. But as growing investor sophistication and competition in insurance markets led to higher credited rates, and as interest rates declined in the 1990s and early 2000s, the net interest spread narrowed quickly and dramatically. As a result, U.S. regulators have permitted minimum statutory accumulation rates to be reduced.

Consistently above-average investment returns should and do provide an insurance company with some competitive advantage in setting premiums. Life insurance companies have found that an improvement as small as 10 basis points (0.10 percent) in the total portfolio yield improves their competitive position and profitability significantly. Portfolio yields for most life portfolios, however, are more similar than different, as Exhibit 3-4 shows. To a large extent, this similarity reflects the role regulation plays in constraining the asset mix and quality characteristics of every life insurance company portfolio and the historical evolution of portfolio asset allocation in that regulatory environment.

Some companies have experimented with using total return rather than interest rate spread to measure their investment portfolios' performance and their products' profitability. When only the asset side of a balance sheet reflects market volatility, it is difficult to use total return measures. To the extent that comprehensive fair market value accounting standards are developed in the future, they will greatly enhance asset/liability management and performance and profitability measurement on a total return basis.

For companies selling annuity and guaranteed investment contracts, competitive invest­ment returns have become necessary and spread margins are narrow. The annuity segment


EXHIBIT 3-4 Portfolio Yields of U.S. Life Insurance Companies: Selected Years, 1975-2004

Major Life Insurance Companies


Industry Rate


Lincoln National

AXA Equitable-NY


























Note: Portfolio yield equals the ratio of net investment income (after expenses and before income taxes) to mean cash and invested assets.

Source: Life Insurance Fact Book (2001); Best's Insurance Reports (2005).



EXHIBIT 3-5 Reserves for Annuities and Guaranteed Investment Contracts for the U.S. Life Insurance Industry: Selected Years, 1970-2002


Percentage of


Total Reserves









Source: Life Insurance Fact Book (2003).


of the life insurance business has accounted for approximately two thirds of total industry reserves for more than a decade (see Exhibit 3-5).

For these lines of business, competition comes from outside as well as from within the industry. These competitive pressures create a dilemma for insurance companies. While insurance companies are required to control risk, many companies feel compelled to mismatch asset/liability durations or downgrade the credit quality of their investments in an attempt to achieve higher returns for competitive reasons.

Segmentation of insurance company portfolios has promoted the establishment of subportfolio return objectives to promote competitive crediting rates for groups of contracts. The major life insurance companies find themselves specifying return requirements by major line of business, the result being that a single company's investment policy may incorporate multiple return objectives.

Another dimension of return objectives for life insurance companies relates to the need to grow surplus to support expanding business volume. Common stocks, equity investments in real estate, and private equity have been the investment alternatives most widely used to achieve surplus growth. Life companies establish return objectives for each of these classes of equity investments to reflect historical and expected returns. Many life insurance companies are evaluating a variety of capital appreciation strategies, as well as financial leverage, to supplement the narrowing contribution to surplus from the newer product lines that are more competitive and have lower profit margins.

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