## _wp0588 - 1. Total Emerging Market Bond and Equity Capitalization in the World, 2001

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### Introduction: role of insurance companies and scope
- Insurance companies are important financial intermediaries in both mature and emerging markets.
- In most mature market countries (except the United States and Canada), and in most parts of Asia and Central Europe, insurance companies are the largest institutional investors in terms of assets under management (AUM).
- In the United States, Canada and in most Latin American countries the largest institutional investors are pension funds.
- Chile is the only country with a matured defined contribution scheme currently but many reformed pension schemes in Latin America are expected to mature in the coming decade.
- The paper focuses on the life insurance industry as the main providers of long-term capital; life insurers tend to be “buy-and-hold” investors and their assets usually far exceed those of general insurers.
- Asset allocation to emerging market assets varies among:
  - mature market insurers,
  - global insurers with subsidiaries in local markets,
  - local insurers.
- Key institutional constraints shaping insurer asset allocation include rating pressure, regulatory constraints, internal risk controls, and the state of development of domestic capital markets (including availability of long-term instruments).

### Key statistics: world and emerging market capitalization, end-2001
- Bond Markets (Million US$ / % of World):
  - Asia: 1,098,700         3.1%
  - Eastern Europe, Middle East, Africa: 694,300            2.0%
  - Latin America: 284,500            0.8%
  - Total Emerging Markets: 2,077,500         5.9%
  - World Bond Markets: 35,101,200       100.0%
- Equity Markets (Million US$ / % of World):
  - Asia: 1,997,577        7.3%
  - Eastern Europe, Middle East, Africa: 521,829           1.9%
  - Latin America: 591,871           2.2%
  - Total Emerging Markets: 3,111,277        11.4%
  - World Equity Markets: 27,343,808      100.0%
- Aggregate:
  - Total Emerging Market Equity and Bond Capitalization: 5,188,777
- Source for table figures: OECD, World Federation of Exchanges, 2001

### Mature market life insurers: allocation patterns and constraints
- Typical allocations and observations:
  - In the United States and Western Europe, insurers without a global presence have portfolios biased towards investment grade fixed income; allocations to emerging markets typically do not exceed 5 percent of their portfolio.
  - In Japan, allocations to emerging markets do not exceed 1 percent of total AUM.
  - Insurers typically do not allocate more than 3–5 percent of their portfolios towards emerging-market debt.
  - Mature market insurers prefer a global asset allocation and mainly impact foreign currency-denominated emerging market assets.
  - Insurers in mature markets are least likely to hold sub-investment grade assets such as emerging-market debt.
  - Some medium and small-sized insurers in mature markets may allocate up to 10 percent of total assets to emerging market securities; these smaller insurers may be more flexible and potentially a less stable investor segment.
- Implication:
  - Given emerging market debt represents 5.9 percent of world bond market capitalization and emerging market equity represents 11.4 percent of world equity capitalization, allocations by mature insurers (typically <5 percent) are described as "far from a globally optimal portfolio" by the paper’s rule-of-thumb.

### Search for yield and alternative investments
- Drivers:
  - The low interest rate environment of the past three years has led investors to search for yields and consider non-traditional or alternative investments.
  - Ratings pressure stemming primarily from the liability side of the balance sheet has constrained insurers’ ability to increase allocations to riskier assets.
- Instruments and practices:
  - Insurers have considered credit-linked and principal protected notes (CLNs and PPNs).
  - Structured products related to emerging market future flow receivables or CDOs are viewed as promising; some insurers have invested in CDOs but in very small amounts.
  - Adequately structured CDOs with long lock-in periods have delivered annualized returns above the 20 percent level (as reported by market sources).
- Risk management and constraints:
  - Larger insurers typically adopt VAR, net-asset valuation (NAV), stress tests and scenario analysis, loss limits and cumulative global credit risk frameworks.
  - Stress testing examples include impact on the balance sheet of up to a 100 basis point move in global interest rates and up to a +/- 30 percent change in the relevant equity market.
  - Internal policies often require selling assets once rated single B because regulations require allocating 100 percent capital towards non-performing assets.
  - Credit default swaps (CDS) are less attractive because CDS must be marked-to-market while bonds do not.
  - Impaired assets held by insurers are a trivial fraction of their overall portfolio; in the United States, distressed assets largely stem from the U.S. high yield market rather than emerging markets.

### Strategic versus tactical allocation; role of global insurers and subsidiaries
- Behavior differences:
  - Global insurers with local subsidiaries tend to follow local business strategies and match local liabilities with local assets.
  - In Central Europe, EU convergence harmonizes local strategy with parent-company strategy; in Asia, capital controls may inhibit local subsidiaries from mimicking parents.
  - Local subsidiaries often invest in local securities and seek to extend duration, supporting development and stability of emerging market securities markets.
  - Insurers without local operations invest a small fraction of global portfolios in emerging market assets and increasingly outsource emerging market mandates to specialists.
- Market impact risk:
  - Large foreign investor positions can materially affect local markets; market participants suggest insurers from Germany, Netherlands, France and Austria were primary holders of about €8 billion in local Hungarian bonds in late 2003, creating vulnerability to market stress.

### Case study: Hungary market volatility, mid‑late 2003
- Timeline and actions:
  - Mid-October 2003: U.S. growth data triggered a 30 bps increase in yields on Polish local bonds; Polish and Hungarian local bond markets are correlated.
  - National Bank of Hungary (NBH) intervened at the long end of the curve; market sources estimate NBH bought about 30 billion HUF (€11 million) of 5 and 10 year bonds.
  - Overnight inter-bank lending rates touched 10.5 percent; the deposit facility at NBH was reduced by 60 billion Hungarian forints (HUF).
  - Short-term interest rates were raised later and reached 13 percent towards end-November 2003.
- Investor concentration and liquidity:
  - Real money accounts from insurance companies from Germany, Netherlands and Austria held over €8 billion in local bonds and could not “play against their own position”; market illiquidity made unwinding difficult.
  - A €100 million position from a hedge fund could impact the HUF by about 5 forints; market liquidity often becomes thin after the five primary dealers quote their €20 million bids each to a marginal €100 million.
- Risks and outlook:
  - The convergence play offered roughly 200–300 bps yield enhancement but the foreign investor base (including insurers) may move elsewhere as countries join the EU.
  - Poland and especially Hungary, with large government bond markets, have significant exposure to a potential disappearance of this investor base.

### Local market insurance companies: market position and product implications
- Market structure:
  - In emerging Asia and Europe, insurance instruments are used for traditional retirement saving; insurance companies are the largest institutional investors in these regions.
  - In Latin America, pension funds dominate as institutional investors and insurance penetration remains low; pension fund growth has contributed to expansion of the life insurance sector and a sharp rise in annuity sales.
- Product design and ALM:
  - Where insurance products have a savings component, products tend to combine savings with standard term life coverage.
  - Shallow domestic capital markets and lack of long-term instruments in many emerging markets have resulted in severe asset-liability mismatches for insurers.
  - Restrictive investment regulations and localization requirements can hinder portfolio diversification and efficient asset allocation, making insurers “dedicated” investors in local instruments.
  - In countries with little intervention on product design and pricing (e.g., Hong Kong SAR and Singapore) the industry has greater flexibility; regulatory interventions such as minimum guaranteed returns can weaken insurer balance sheets in low interest rate environments.

### Box 2 — Investment drivers and constraints; asset allocation and liability matching
- Investment drivers:
  - Insurers’ reliance on investment returns has increased as their balance sheets have rapidly expanded.
  - Investment decisions of life insurance companies operating in emerging markets depend on regulatory constraints, the development of local capital markets, and risk management guidelines.
- Asset allocation and liability matching:
  - Insurers must choose optimal asset mixes permitted by investment restrictions and internal risk control guidelines and match assets and liabilities to minimize adverse balance sheet impacts.
  - Regulations and internal guidelines influence permitted instruments and the balance between fixed-income and equity exposures.
- Local investment requirements and market limitations:
  - In most emerging market economies, insurers are required to maintain local assets to match local liabilities.10
  - Thus most local insurance assets are invested in local capital markets.
  - Regulations typically put strict limits on various instruments, which usually favor fixed-income instruments over equity.
  - Even when investment regulations are not binding, insurers are constrained by the lack of alternative instruments, illiquidity of local markets, and resulting asset and liability mismatches.
- Footnote:
  - 10 The “localization” requirement is intended for policyholder protection in cases of insurer’s bankruptcy so that assets are held locally and can be used to compensate the policyholders. Hong Kong SAR is an exception; the Office of the Commissioner of Insurance is evaluating the current regulation on investment with a view to strengthen asset valuation and safeguard policyholder assets in the future.

### Box 2 — The Impact of Emerging Market Crises on Insurance Companies: crisis effects and resilience
- Crisis effects on insurers (empirical):
  - Financial crises produce sharp declines in output, massive devaluation, increasing inflation and interest rates, and collapse in asset values; consequences include lower demand for insurance products, lower premiums, higher early terminations (lapses), higher claims, decline in asset values and higher reserves required on the liability side, and major threats to solvency and liquidity.
  - Swiss Re (2003) evidence: New life insurance business collapsed during the year of the crisis; lapse ratios increased by almost three-fold in the year after the crisis.
  - Lapse ratios: increased beginning two years before the crisis in Argentina (T = 2002) and for Indonesia and Thailand (T = 1998).
  - Savings-type policies were most sensitive to income/wealth changes; lapse increases particularly significant where life products were denominated in U.S. dollars (Indonesia and Argentina).
  - Post-crisis Argentina: majority of new products sold were one-year local-currency denominated pure insurance products.
- Balance sheet and solvency effects:
  - Virtually all local assets lost value; claims were higher, requiring higher reserves relative to premiums.
  - Equity relative to capital declined; solvency (capital-to-reserve and capital-to-premium ratios) was questioned.
  - Insufficient ALM and poor risk management aggravated impact and led to bankruptcies (example: Korea).
- Differential resilience:
  - Foreign insurers generally fared better due to better-diversified investment portfolios, more sophisticated ALM, and access to additional capital from parent companies.
  - Result: foreign insurers gained market share after crises in some countries (Mexico, Indonesia, Thailand).

### ALM constraints, product responses and market structure indicators
- ALM constraints and market structure:
  - ALM principle: segment liabilities by duration and match asset composition to control interest rate risk via duration match.
  - Key constraints: lack of long-term fixed-income instruments and relative illiquidity in bond and equity markets.
  - Example: a typical Korean life insurer’s liability duration > 10 years, average asset duration = 3½ years.
  - Insurers often invest in the long-end of the local fixed-income market; in countries like Thailand, Singapore, Poland, Hungary insurance companies are the largest investors in the 10-year segment.
  - Market estimate: in Hungary, the two largest insurance companies hold around 75 percent of the 10-year benchmark bond.
- Government bond market turnover ratios (share of annual bond turnover of securities outstanding, as of 2002; Korea turnover ratios noted subsequently):
  - China: 0.4
  - Hong Kong SAR: 15.6
  - Korea: 6.5
  - Malaysia: 3.7
  - Singapore: 5.0
  - Thailand: 2.5
  - Note: for Korea, turnover ratio increased to 7.6 (2003) and 8.6 (2004).
- Paucity of derivatives (interest rate swaps, swaptions, caps, floors, currency swaps) constrains ALM; cross-border duration pickup limited by hedging costs and lack of long-duration currency swaps.
- Liability-side management responses:
  - Move toward repricing existing products and offering shorter-duration products.
  - Unit-linked products gaining popularity in many South-East Asian and Central and Eastern European countries; not allowed in Thailand but available in Singapore, Korea, Hong Kong SAR, Indonesia, Malaysia, Poland, and Hungary.
    - Hungary: two thirds of new life insurance contracts are unit-linked.
    - Poland: one third of life insurance products are unit-linked (Dorfman and Ennsfellner 2002).
    - A 20-year unit-linked product can have an effective duration of only 6 years (by some estimates).
  - Unit-linked products transfer some asset risk to policyholders and facilitate ALM but create competitive pressure on the mutual fund industry.

### Currency denomination and “dollarization” issues
- Latin America:
  - Significant share of life contracts in Mexico and Argentina specified in foreign currency (usually US dollars).
  - Mexico: regulators require that dollar-linked liabilities be matched with dollar-linked assets; insurers are among largest holders of sovereign dollar-denominated external debts.
  - Colombia: no formal ALM guidelines, yet local insurers hold more than 20 percent of their assets in foreign-currency-denominated assets and may invest in foreign-currency debt of any investment-grade sovereign or corporate.
- Regulatory differences affect ability to match currency risks and to diversify externally.

### Regulatory impact on balance sheets and investment behavior
- Main balance-sheet risks: (i) investment risks, (ii) underwriting risks, (iii) asset/liability matching risks.
- Solvency regimes:
  - Most emerging markets adopt solvency requirements similar to EU Directives; some (Singapore, Indonesia, Malaysia, Taiwan Province of China) have risk based capital (RBC) regimes similar to U.S. and Japan.
  - EU-based systems often include only underwriting risk in solvency calculations; U.S. and Japanese systems include investment and ALM mismatching risks.
  - Critics argue the European system inadequately addresses investment risks; alternative is RBC with prudent person rule.
- Investment restrictions and observed allocations (selected life insurer asset allocations, end-2002 unless noted; percent of total):
  - Hong Kong SAR (2000/2001 data): Cash & Deposits 1; Equities 7; Bonds 35; Foreign Securities 38; Loans 0; Real Estate 0; Other 20; Total 100
  - Korea: Cash & Deposits 2; Equities 7.5; Bonds 29.8; Foreign Securities 6.2; Loans 26.5; Real Estate 5.5; Other 22.5; Total 100
  - Malaysia: Cash & Deposits 29; Equities 0; Bonds 53; Foreign Securities 0; Loans 9; Real Estate 4; Other 4; Total 100
  - Thailand: Cash & Deposits 8; Equities 9; Bonds 64; Foreign Securities 0; Loans 11; Real Estate 3; Other 5; Total 100
  - Hungary: Cash & Deposits 3; Equities 5; Bonds 91; Foreign Securities 0; Loans 0; Real Estate 0; Other 0; Total 100
  - Poland: Cash & Deposits 4; Equities 11; Bonds 83; Foreign Securities 0; Loans 0; Real Estate 1; Other 0; Total 100
  - Mexico: Cash & Deposits 2; Equities 6; Bonds 80; Foreign Securities 0; Loans 3; Real Estate 7; Other 3; Total 100
  - Colombia: Cash & Deposits 3; Equities 11; Bonds 68; Foreign Securities 7; Loans 8; Real Estate 3; Other 0; Total 100
  - South Africa: Cash & Deposits 7; Equities 48; Bonds 15; Foreign Securities 14; Loans 0; Real Estate 5; Other 10; Total 100
- Regulatory interventions on liabilities:
  - Minimum guaranteed returns can generate negative spreads and solvency stress; examples of higher guaranteed returns than market rates reported for Thailand, Croatia, Korea.
  - Negative spreads observed in Germany, the United Kingdom, Central and Eastern Europe, and Asia during recent low-interest-rate environment.
  - Thailand example: guaranteed return at maturity plus guaranteed surrender value can force insurers to sell bond portfolios at a loss when policyholders surrender to seek higher market rates.
- Insurer risk-taking to enhance yields:
  - Investment in structured credit products (synthetic emerging market CDOs, CLNs, asset-backed securities), project loans, private placements, and providing guarantees on bank principal-guaranteed products for upfront fees.
  - Some insurers adopt absolute return strategies at expense of duration gap.
  - Reverse repo / securities lending is under-utilized despite permissibility in countries such as Hungary, Poland, Singapore, Hong Kong SAR.
- Marking-to-market practices:
  - Regulations typically do not require daily mark-to-market for assets; liabilities are usually not marked-to-market.
  - Asset valuation reporting often quarterly; asymmetry (assets market-valued, liabilities not) can lead to undesirable consequences during market downturns (e.g., need to raise capital or sell equities in falling market).

### Policy implications and recommendations
- Market development:
  - Develop local securities markets to support insurers’ risk management and financial intermediation by issuing long-duration bonds and extending yield curves beyond the mid-range.
- Regulatory reform:
  - Improve regulatory frameworks to account for investment and ALM risks; incorporate measures of investment risk and duration into investment regulations, or adopt an RBC regime combined with the prudent person rule on investment.
  - Quantitative investment limits can produce homogenous asset allocations and may not reduce investment risk; they can increase insurance costs.
- Prudential balance:
  - With appropriate solvency safeguards, insurers can be stable long-term investors and stimulate capital-market development through demand for hedging instruments and new products.
  - Caution: rapid growth of life insurance AUM without corresponding market development can compete for limited long-term instruments, lead to excessive market volatility, underpricing of credit risk, and potential asset price bubbles.

*Source: IMF staff paper content from _wp0588 - 1. Total Emerging Market Bond and Equity Capitalization in the World, 2001 (excerpts provided).*

### 1. Total Emerging Market Bond and Equity Capitalization in the World, 2001 ...............5

### _wp0588 - 1. Total Emerging Market Bond and Equity Capitalization in the World, 2001 ...............5

### Introduction: role of insurance companies and scope
- Insurance companies are important financial intermediaries in both mature and emerging markets.
- In most mature market countries (except the United States and Canada), and in most parts of Asia and Central Europe, insurance companies are the largest institutional investors in terms of assets under management (AUM).
- In the United States, Canada and in most Latin American countries the largest institutional investors are pension funds.  
- Chile is the only country with a matured defined contribution scheme currently but many reformed pension schemes in Latin America are expected to mature in the coming decade.
- The paper focuses on the life insurance industry as the main providers of long-term capital; life insurers tend to be “buy-and-hold” investors and their assets usually far exceed those of general insurers.
- Asset allocation to emerging market assets varies among:
  - mature market insurers,
  - global insurers with subsidiaries in local markets,
  - local insurers.
- Key institutional constraints shaping insurer asset allocation include rating pressure, regulatory constraints, internal risk controls, and the state of development of domestic capital markets (including availability of long-term instruments).

### Key statistics: world and emerging market capitalization, end-2001 (Table 1)
- Bond Markets (Million US$ / % of World):
  - Asia: 1,098,700         3.1%
  - Eastern Europe, Middle East, Africa: 694,300            2.0%
  - Latin America: 284,500            0.8%
  - Total Emerging Markets: 2,077,500         5.9%
  - World Bond Markets: 35,101,200       100.0%
- Equity Markets (Million US$ / % of World):
  - Asia: 1,997,577        7.3%
  - Eastern Europe, Middle East, Africa: 521,829           1.9%
  - Latin America: 591,871           2.2%
  - Total Emerging Markets: 3,111,277        11.4%
  - World Equity Markets: 27,343,808      100.0%
- Aggregate:
  - Total Emerging Market Equity and Bond Capitalization: 5,188,777
- Source for table figures: OECD, World Federation of Exchanges, 2001

### Mature market life insurers: allocation patterns and constraints
- Typical allocations:
  - In the United States and Western Europe, insurers without a global presence have portfolios biased towards investment grade fixed income; allocations to emerging markets typically do not exceed 5 percent of their portfolio.
  - In Japan, allocations to emerging markets do not exceed 1 percent of total AUM.
  - Insurers typically do not allocate more than 3–5 percent of their portfolios towards emerging-market debt.
- Observations:
  - Mature market insurers prefer a global asset allocation and mainly impact foreign currency-denominated emerging market assets.
  - Insurers in mature markets are least likely to hold sub-investment grade assets such as emerging-market debt.
  - Some medium and small-sized insurers in mature markets may allocate up to 10 percent of total assets to emerging market securities (compared to around 3–5 percent for large insurers); these smaller insurers may be more flexible and potentially a less stable investor segment.
- Implication:
  - Given emerging market debt represents 5.9 percent of world bond market capitalization and emerging market equity represents 11.4 percent of world equity capitalization, allocations by mature insurers (typically <5 percent) are "far from a globally optimal portfolio" by the paper’s rule-of-thumb.

### Search for yield and alternative investments
- Drivers:
  - The low interest rate environment of the past three years has led investors to search for yields and consider non-traditional or alternative investments.
  - Ratings pressure stemming primarily from the liability side of the balance sheet has constrained insurers’ ability to increase allocations to riskier assets.
- Instruments and practices:
  - Insurers have considered credit-linked and principal protected notes (CLNs and PPNs) to better match liability profiles.
  - Structured products related to emerging market future flow receivables or CDOs (Collateralized Debt Obligations) are viewed as promising; some insurers have invested in CDOs but in very small amounts.
  - Adequately structured CDOs with long lock-in periods have delivered annualized returns above the 20 percent level (as reported by market sources).
- Risk management:
  - Larger insurers typically adopt VAR, net-asset valuation (NAV), stress tests and scenario analysis, loss limits and cumulative global credit risk frameworks.
  - Stress testing examples: impact on the balance sheet of up to a 100 basis point move in global interest rates and up to a +/- 30 percent change in the relevant equity market.
- Constraints on sub-investment grade assets and CDS:
  - Internal policies often require selling assets once rated single B because regulations require allocating 100 percent capital towards non-performing assets.
  - Holding impaired assets can permanently “set aside” capital even if the asset later recovers to secondary market prices.
  - Credit default swaps (CDS) are less attractive because CDS must be marked-to-market while bonds do not, reducing their relative appeal.
- Empirical point:
  - Impaired assets held by insurers are a trivial fraction of their overall portfolio; in the United States, distressed assets largely stem from the U.S. high yield market rather than emerging markets.

### Strategic versus tactical allocation; role of global insurers and subsidiaries
- Global insurers with local subsidiaries tend to follow local business strategies and match local liabilities with local assets.
- In Central Europe, EU convergence harmonizes local strategy with parent-company strategy; in Asia, capital controls may inhibit local subsidiaries from mimicking parents.
- Local subsidiaries often invest in local securities and seek to extend duration, supporting development and stability of emerging market securities markets.
- Insurers without local operations invest a small fraction of global portfolios in emerging market assets and increasingly outsource emerging market mandates to specialists.
- Large foreign investor positions can materially affect local markets:
  - Example: market participants suggest insurers from Germany, Netherlands, France and Austria were primary holders of about €8 billion in local Hungarian bonds in late 2003; the market was illiquid to unwind such large positions, creating vulnerability to market stress.

### Case study (Box 1): Hungary market volatility, mid‑late 2003
- Context and central bank actions:
  - Mid-October 2003: U.S. growth data triggered a 30 bps increase in yields on Polish local bonds; Polish and Hungarian local bond markets are correlated.
  - National Bank of Hungary (NBH) intervened at the long end of the curve to cushion losses and defend the exchange rate and short-term interest rates (short-term rates were already the highest in the region at 9.5 percent).
  - Market sources estimate NBH bought about 30 billion HUF (€11 million) of 5 and 10 year bonds.
  - Overnight inter-bank lending rates touched 10.5 percent; the deposit facility at NBH was reduced by 60 billion Hungarian forints (HUF).
  - Short-term interest rates were raised later and reached 13 percent towards end-November 2003.
- Investor concentration and market liquidity:
  - Real money accounts from insurance companies from Germany, Netherlands and Austria held over €8 billion in local bonds and could not “play against their own position”; market illiquidity made unwinding difficult.
  - A €100 million position from a hedge fund could impact the HUF by about 5 forints; market liquidity often becomes thin after the five primary dealers quote their €20 million bids each to a marginal €100 million.
- Risks and outlook:
  - The convergence play offered roughly 200–300 bps yield enhancement but the foreign investor base (including insurers) may move elsewhere as countries join the EU; Greece and Ireland experience suggests authorities may need to support budget deficits if the investor base shrinks.
  - Poland and especially Hungary, with large government bond markets, have significant exposure to a potential disappearance of this investor base.

### Local market insurance companies: market position and product implications
- In emerging Asia and Europe, insurance instruments are used for traditional retirement saving; insurance companies are the largest institutional investors in these regions.
- In Latin America, pension funds dominate as institutional investors and insurance penetration remains low; however, pension fund growth has contributed to expansion of the life insurance sector and a sharp rise in annuity sales.
- Where insurance products have a savings component, products tend to combine savings with standard term life coverage.
- Shallow domestic capital markets and lack of long-term instruments in many emerging markets have resulted in severe asset-liability mismatches for insurers.
- Restrictive investment regulations and localization requirements can hinder portfolio diversification and efficient asset allocation, making insurers “dedicated” investors in local instruments.
- In countries with little intervention on product design and pricing (e.g., Hong Kong SAR and Singapore) the industry has greater flexibility in managing products and risks; elsewhere, regulatory interventions such as minimum guaranteed returns can weaken insurer balance sheets in low interest rate environments.

*Source: IMF staff paper content from _wp0588 - 1. Total Emerging Market Bond and Equity Capitalization in the World, 2001 (excerpts provided).*

### Box 2 for an analysis on the impact of financial crisis on insurers). With the rapid expansion

### Box 2 for an analysis on the impact of financial crisis on insurers). With the rapid expansion of their balance sheets, insurers increasingly rely on investment returns to meet future obligations towards policyholders as well as generating surpluses for shareholders.

### Investment drivers and constraints
- Insurers’ reliance on investment returns has increased as their balance sheets have rapidly expanded.
- Investment decisions of life insurance companies operating in emerging markets depend on:
  - regulatory constraints,
  - the development of local capital markets,
  - risk management guidelines.

### Asset allocation and liability matching
- In making asset allocation decisions, insurers must:
  - choose the optimal asset mix by making strategic and tactical allocation among instruments permitted by investment restrictions and internal risk control guidelines,
  - match assets and liabilities so as to minimize the impact of adverse market developments on the balance sheet.
- Regulations and internal guidelines influence the permitted instruments and the balance between fixed-income and equity exposures.

### Local investment requirements and market limitations
- In most emerging market economies, insurers are required to maintain local assets to match local liabilities.10
- Thus most local insurance assets are invested in local capital markets.
- Regulations typically put strict limits on various instruments, which usually favor fixed-income instruments over equity.
- Even when investment regulations are not binding, insurers are constrained by:
  - the lack of alternative instruments,
  - illiquidity of local markets,
  - resulting asset and liability mismatches.

### Footnote content (as presented)
- 10 The “localization” requirement is intended for policyholder protection in cases of insurer’s bankruptcy so that assets are held locally and can be used to compensate the policyholders. Hong Kong SAR is an exception; the Office of the Commissioner of Insurance is evaluating the current regulation on investment with a view to strengthen asset valuation and safeguard policyholder assets in the future.

*From: _wp0588 - Box 2 for an analysis on the impact of financial crisis on insurers).*

### Box 2. The Impact of Emerging Market Crises on Insurance Companies

### Box 2. The Impact of Emerging Market Crises on Insurance Companies

### Crisis effects on insurers: empirical findings
- Financial crises produce sharp declines in output, massive devaluation, increasing inflation and interest rates, and collapse in asset values; consequences for insurers include:
  - Lower demand for insurance products, lower premiums, and higher early terminations (lapses).
  - Higher claims due to higher inflation and adverse environment.
  - Decline in asset values and higher reserves required on the liability side.
  - Major threats to solvency and liquidity of the insurance industry.
- Swiss Re (2003) evidence:
  - New life insurance business collapsed during the year of the crisis; lapse ratios increased by almost three-fold in the year after the crisis.
  - In Argentina, lapse ratios steadily increased beginning two years before the crisis (T = 2002 for Argentina; T = 1998 for Indonesia and Thailand).
  - Savings-type policies were most sensitive to income/wealth changes and saw the most pronounced decline in premiums.
  - Lapse increases were particularly significant in Indonesia and Argentina where many life products were denominated in U.S. dollars.
  - Post-crisis Argentina: majority of new products sold were one-year local-currency denominated pure insurance products.
- Balance sheet and solvency effects:
  - Virtually all local assets lost value; claims were higher, requiring higher reserves relative to premiums.
  - Equity relative to capital declined; solvency (capital-to-reserve and capital-to-premium ratios) was questioned.
  - Insufficient ALM and poor risk management aggravated impact and led to bankruptcies (example: Korea).

### Differential resilience: local vs foreign insurers
- Foreign insurers generally fared better due to:
  - Better-diversified investment portfolios and more sophisticated ALM.
  - Access to additional capital from parent companies.
- Result: foreign insurers gained market share after crises in some countries (Mexico, Indonesia, Thailand).

### Asset-Liability Management (ALM): constraints and responses
- ALM principle: segment liabilities by duration and match asset composition to control interest rate risk via duration match.
- Key constraints in emerging markets:
  - Lack of long-term fixed-income instruments and relative illiquidity in bond and equity markets.
  - Example: a typical Korean life insurer’s liability duration > 10 years, average asset duration = 3½ years.
  - Insurers often invest in the long-end of the local fixed-income market; in countries like Thailand, Singapore, Poland, Hungary insurance companies are the largest investors in the 10-year segment.
  - Market estimate: in Hungary, the two largest insurance companies hold around 75 percent of the 10-year benchmark bond.
- Government bond market turnover ratios (share of annual bond turnover of securities outstanding, as of 2002; for Korea, turnover ratio increased to 7.6 (2003) and 8.6 (2004)):
  - China: 0.4
  - Hong Kong SAR: 15.6
  - Korea: 6.5
  - Malaysia: 3.7
  - Singapore: 5.0
  - Thailand: 2.5
- Paucity of derivatives (interest rate swaps, swaptions, caps, floors, currency swaps) constrains ALM; cross-border duration pickup limited by hedging costs and lack of long-duration currency swaps.
- Liability-side management:
  - Move toward repricing existing products and offering shorter-duration products.
  - Unit-linked products gaining popularity in many South-East Asian and Central and Eastern European countries; not allowed in Thailand but available in Singapore, Korea, Hong Kong SAR, Indonesia, Malaysia, Poland, and Hungary.
  - Examples:
    - Hungary: two thirds of new life insurance contracts are unit-linked.
    - Poland: one third of life insurance products are unit-linked (Dorfman and Ennsfellner 2002).
    - A 20-year unit-linked product can have an effective duration of only 6 years (by some estimates).
  - Unit-linked products transfer some asset risk to policyholders and facilitate ALM but create competitive pressure on the mutual fund industry.

### Currency denomination and “dollarization” issues
- In Latin America (Mexico, Argentina) significant share of life contracts specified in foreign currency (usually US dollars).
  - Mexico: regulators require that dollar-linked liabilities be matched with dollar-linked assets; insurers are among largest holders of sovereign dollar-denominated external debts.
  - Colombia: no formal ALM guidelines, yet local insurers hold more than 20 percent of their assets in foreign-currency-denominated assets and may invest in foreign-currency debt of any investment-grade sovereign or corporate.
- Regulatory differences affect ability to match currency risks and to diversify externally.

### Regulatory impact on balance sheets and investment behavior
- Main balance-sheet risks: (i) investment risks, (ii) underwriting risks, (iii) asset/liability matching risks.
- Most emerging markets adopt solvency requirements similar to EU Directives; some (Singapore, Indonesia, Malaysia, Taiwan Province of China) have risk based capital (RBC) regimes similar to U.S. and Japan.
  - EU-based systems often include only underwriting risk in solvency calculations; U.S. and Japanese systems include investment and ALM mismatching risks.
  - Critics argue the European system inadequately addresses investment risks; alternative is RBC with prudent person rule.
- Investment restrictions:
  - Many jurisdictions prescribe specific investments and percentage limits by asset class or region, often biasing portfolios toward fixed-income instruments and limiting equity, real estate, and foreign investments.
  - Selected industry asset allocation (life insurers, as of end-2002 unless noted; percent of total) — notable entries:
    - Hong Kong SAR (2000/2001 data): Cash & Deposits 1; Equities 7; Bonds 35; Foreign Securities 38; Loans 0; Real Estate 0; Other 20; Total 100
    - Korea: Cash & Deposits 2; Equities 7.5; Bonds 29.8; Foreign Securities 6.2; Loans 26.5; Real Estate 5.5; Other 22.5; Total 100
    - Malaysia: Cash & Deposits 29; Equities 0; Bonds 53; Foreign Securities 0; Loans 9; Real Estate 4; Other 4; Total 100
    - Thailand: Cash & Deposits 8; Equities 9; Bonds 64; Foreign Securities 0; Loans 11; Real Estate 3; Other 5; Total 100
    - Hungary: Cash & Deposits 3; Equities 5; Bonds 91; Foreign Securities 0; Loans 0; Real Estate 0; Other 0; Total 100
    - Poland: Cash & Deposits 4; Equities 11; Bonds 83; Foreign Securities 0; Loans 0; Real Estate 1; Other 0; Total 100
    - Mexico: Cash & Deposits 2; Equities 6; Bonds 80; Foreign Securities 0; Loans 3; Real Estate 7; Other 3; Total 100
    - Colombia: Cash & Deposits 3; Equities 11; Bonds 68; Foreign Securities 7; Loans 8; Real Estate 3; Other 0; Total 100
    - South Africa: Cash & Deposits 7; Equities 48; Bonds 15; Foreign Securities 14; Loans 0; Real Estate 5; Other 10; Total 100
- Regulatory interventions on liabilities (minimum guaranteed returns) can generate negative spreads and solvency stress:
  - Some countries (Thailand, Croatia, Korea) reportedly had guaranteed returns higher than market rates.
  - Negative spreads observed in Germany, the United Kingdom, Central and Eastern Europe, and Asia during recent low-interest-rate environment.
  - Thailand example: guaranteed return at maturity plus guaranteed surrender value can force insurers to sell bond portfolios at a loss when policyholders surrender to seek higher market rates.
- Insurer risk-taking to enhance yields:
  - Investment in structured credit products (synthetic emerging market CDOs, CLNs, asset-backed securities), project loans, private placements, and providing guarantees on bank principal-guaranteed products for upfront fees.
  - Some insurers adopt absolute return strategies at expense of duration gap.
  - Reverse repo / securities lending is under-utilized despite permissibility in countries such as Hungary, Poland, Singapore, Hong Kong SAR.
- Marking-to-market practices:
  - Regulations typically do not require daily mark-to-market for assets; liabilities are usually not marked-to-market.
  - Asset valuation reporting often quarterly; asymmetry (assets market-valued, liabilities not) can lead to undesirable consequences during market downturns (e.g., need to raise capital or sell equities in falling market).

### Policy implications and recommendations
- Develop local securities markets to support insurers’ risk management and financial intermediation:
  - Issue long-duration bonds and extend yield curves beyond the mid-range.
- Improve regulatory frameworks to account for investment and ALM risks:
  - Incorporate measures of investment risk and duration into investment regulations, or adopt an RBC regime combined with the prudent person rule on investment.
  - Quantitative investment limits can produce homogenous asset allocations and may not reduce investment risk; they can increase insurance costs.
- With appropriate solvency safeguards, insurers can be stable long-term investors and stimulate capital-market development through demand for hedging instruments and new products.
- Caution: rapid growth of life insurance assets under management (AUM) without corresponding market development can:
  - Compete for limited long-term instruments,
  - Lead to excessive market volatility, underpricing of credit risk, and potential asset price bubbles.

*Source: Swiss Re, Sigma No. 7/2003; T: refers to the year of the financial crisis, =1998 for Indonesia and Thailand, and 2002 for Argentina.*

### REFERENCES

### _wp0588 - REFERENCES

### Reference list

- Babbel, David, and Anthony Santomero, 1996, “Risk Management by Insurers: An Analysis of the Process,” The Wharton Financial Institutions Center Working Paper No. 96–16 (Philadelphia: The Wharton School, University of Pennsylvania).

- Briys, E., and F. de Varenne, 1996, “On the Risk of Life Insurance Liabilities: Debunking Some Common Pitfalls,” The Wharton Financial Institutions Center Working Paper No. 96–29 (Philadelphia: The Wharton School, University of Pennsylvania).

- Dickinson, Gerry, 2002, “The Search for an International Accounting Standard for Insurance: Report to the Accounting Task Force of the Geneva Association,” The Geneva Papers on Risk and Insurance, Vol. 28, No. 2, pp. 151–75.

- Dorfman, Mark, and Karl Ennsfellner, 2002, “Insurance in Transition Economies: Poland, Czech Republic, and Hungary,” International Insurance Foundation Occasional Paper No. 5 (Washington).

- Garcia-Cantera, José, Steve Faucher, Flavia Montoro, and Laura Molina, 2002, “Private Pension Funds in Latin America,” in Equity Research: Latin America, Salomon Smith Barney, (December).

- International Monetary Fund, 2002, Global Financial Stability Report, World Economic and Financial Surveys (Washington), September.

- –––––, 2003, Global Financial Stability Report, World Economic and Financial Surveys (Washington), September.

- Kwon, W., 2001, “Toward Free Trade in Services: The ASEAN Insurance Market,” International Insurance Foundation Occasional Paper No. 3 (Washington).

- MacKenzie, Sandy, 2002, “The Role of Private Sector Annuities Markets in an Individual Accounts Reform of a Public Pension Plan,” IMF Working Paper No. 02/161 (Washington: International Monetary Fund).

- Mathieson, Donald J., Jorge E. Roldos, Ramana Ramaswamy, and Anna Ilyina, 2004, Emerging Local Securities and Derivatives Markets, World Economic and Financial Surveys (Washington: International Monetary Fund).

- Munich Re Group, 2002, Annual Report, pp. 167–9.

- OECD, 2000, “Institutional Investors in Latin America,” (Paris: Organization for Economic Cooperation and Development).

- –––––, 2001, “Insurance Regulation and Supervision in Asia and Latin America,” (Paris: Organization for Economic Cooperation and Development).

- Oswald, William, and David Sekiguchi, 2002, “Mexico’s Local Markets” in Global Markets Research, Emerging Markets (New York: Deutsche Bank).

- Reactions, 2002, Triple-A Ratings—A Dying Breed? (November).

- Swiss Re, 2000, “Solvency of Non-Life Insurers: Balancing Security and Profitability Expectations,” Publication Brief No. 1/2000.

*Source: _wp0588 - REFERENCES*

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