Question

Why do banks and life insurance companies/pension funds have different investment strategies and different tolerances to interest rate risk and reinvestment risk?

Answer 1

Investment strategy of banks vs. insurance companies:

Both banks & insurance companies are considered to be financial intermediaries. Yet they operate differently.

The strategy that is followed by the banks is that it pays interest to those who make deposits with it & charges interest from those who borrowed from the banks. This difference is considered to be an income for the banks.

There can be two scenarios for the bank:

• When deposits are low & loan demand is high:

1. The investments are used as collateral & borrowing & utilizing this to meet the loan demand.
2. Selling investments to meet the loan demand.

• When deposits are more & loan demand is weak:

1. Using investments to increase the bank’s earning capacity.
2. Retrieving pledged investments to convert it into an earning asset.

All financial intermediaries are subject to interest rate risk. If the bank pays an investor competitive interest rate, it has to increase the rates if the economic conditions demand. This risk is mitigated because the banks also charge a higher rate on its loans. These changes in rates can have an adverse impact on bank’s investments.

Strategy of insurance companies:

1. The asset allocation in terms of asset mix over the investment categories. Not more than 20% of reserves should be invested in equities without prior approval.
2. The asset portfolio must take into consideration the insurer’s risk profile & their liquidity needs.
3. Any restrictions on assets.
4. Company’s approach to the use of derivatives or structured products.
5. Definition for scope of investment flexibility through setting of quantitative asset exposure limits.

Insurance companies are also subject to interest rate risk. They invest their premiums in various investments such as bonds & real estate which can see a decline in the value of investments when interest rates go up. In case of low interest rates, they face the risk of not getting sufficient return from investments in order to pay the policy holders at times of claims due.