Investment Strategy for Takaful: Nurturing Metamorphosis of Assets

Investment Strategy for Takaful: Nurturing metamorphosis of Assets

Investment Strategy for Takaful: Nurturing metamorphosis of Assets

Syed Danish Ali

Table of Contents

1.Executive Summary

2.Investment strategy- Key Considerations

3.Other Main Tenants of Investment Strategy

4.Takaful Considerations for Investment Strategy

5.Review of Investment Policy and Asset and Liability Management (ALM)

6.Liquidity Analysis

7.Capital Adequacy Assessment

8.Conclusion

1.Executive Summary

Introduction

1.1.Investment policy of Islamic Insurance or Takaful Companies requires that the investments should be made on a prudent basis with a long-term perspective whilst striking a fair balance between risk and return. The policy also requires that the portfolio should be well diversified amongst various asset classes such as bank deposits, equities, Bonds, debt instruments, real estate etc. There is a strong emphasis in the policy on compliance with the Investment Regulations for Insurance Companies of the relevant Regulator.

1.2.This report is made for Takaful company that mainly writes short term general and group life business (no long-term insurance business as that requires very different investment strategy). Country has been chosen as UAE. The company has to maintain a liability driven investment strategy to map the liability duration and hold agreed strategic asset allocation derived via this process to minimize the asset-liability mismatch risk and liquidity risk.

1.3.In order to determine a suitable investment strategy available suitable assets, need to be identified and the strategy developed with this in mind. The asset portfolio should, from a matching perspective, be similar.

1.4.Most debt securities available in the UAE are denominated in USD. Given that the Emirati Dirham is pegged to the US Dollar we consider investments in USD denominated securities to be appropriate.

1.5.The basis for recommendation of the investment strategy for short terminsurance business is subject to a number of assumptions regarding asset profiles, liability profiles, management’s approach to selection of assets, and attitude to investment risk and drive for achieving higher investment return.

1.6.Asset-Liability Management is a key function in insurance investment management. Insurers’ balance sheets are dominated by the investments on the asset side and reserves for future claims and benefits on the liability side (ignoring unit linked investments which have identical offsetting liabilities). So, relative changes in value of investments relative to insurance liabilities can have a significant impact on shareholders’ equity. As a result, the company must hold assets not just to cover the expected claims but also unexpected, larger claims and be able to absorb adverse results from any asset-liability mismatch.

1.7.To sum up, investment strategy can be illustrated as follows:

2.Investment strategy- Key Considerations

Establishing the context

2.1.A Takaful company has a variety of key stakeholders focused on, in some cases, vastly different metrics. The Company must answer to policyholders, shareholders, rating agencies and regulators, to name a few. Each stakeholder within the insurer’s universe serves a unique purpose, with its own objectives and constraints that sometimes complement and at other times conflict with each other. A limited sample of difference in metrics across stakeholders can be visualized as follows:

2.2.Risk reporting for investments is indeed crucial. Regular and routine monitoring of risks includes sensitivity, stress tests, multiple measures of risks and contingency planning. Risk reporting needs to be a living, nimble process that feeds back into the risk governance. The Companyshould also regularly determine where and how the ALM process and constraints fit into the overall risk management framework.

Investment Objectives

2.3.The Takaful companyshould recognize the importance of separating the responsibilities for managing their insurance businesses from managing the investments backing their reserves and capital. Accordingly, itshould avoid cash flow underwriting. Cash flow underwriting is the practice where investment returns are disturbingly relied upon to convert underwriting losses into net profits. Underwriting decisions are kept distinct from investment decisions. Underwriting income should usually outpace Investment income, testifying to the Company’s capacity to generate surplus from its core business.

2.4.The Companyshould also believe that complex innovations be cautiously adopted. Complex forms of derivatives, investment instruments as well as collateralization insurance or complex liability products should be avoided as it is difficult to realize their precise consequences until it is usually too late. The company believes that Asset Liability modelling and management should be improved and enhanced but investment products should remain legible to all the stakeholders involved.

2.5.Due to the scale of investments in InsuranceCompany’s balance sheet and the impact of investment results on its profitability, the management of these investments is a key function in an Insurance Company that can create significant value for the Company’s policyholders and shareholders. To accomplish this value creation, Investment Management must use a systematic and structured investment process focusing on the value drivers that matter most.

2.6.When an Insurance Company determines its investment strategy and investment risk appetite, it cannot ignore the liability side of its balance sheet – the reserves for future claims and benefits and shareholder capital.

2.7.Insurance companies have assets (investments) and liabilities (future claims and benefits) whose values change as capital market conditions change. The challenge for insurance investment management is to manage the potential mismatch in value of its assets and liabilities and to ensure that such a mismatch will not endanger the Company as a going concern.

2.8.Insurance investment risk, therefore, is when investments become insufficient to pay the liabilities due to adverse changes in capital markets. The analysis and management of these relative movements is called Asset-Liability Management (ALM).

2.9.Investment Management should have the mission to achieve superior risk-adjusted investment returns relative to liabilities.

2.10.The investment philosophy of the company can be encapsulated in the following illustration:

2.11.Overall risk exposure in investment can be low when there are large cash and bank balances which substantially reduce the major risk of liquidity to the Company. Moreover, the investments are mostly made in readily tradable securities and liquid bonds, which further keep the risk in check.

2.12.The companyshould Strive to create long-term value for the Company’s policyholders and shareholders by developing and implementing one investment strategy that optimizes the investment risk-return profile for these stakeholders. The Company can:

• Measure investment risks and returns relative to liabilities on an economic or market value basis
• Consider regulatory restrictions and accounting targets as important
• Minimize short-term activism and strive for best execution when transacting in the capital markets.

2.13.The company believes that it can only capture extra returns if it has:

• A long-term strategy to take the necessary risks;
• Understand the risks it incurs; and
• Can afford the risks it is taking at any time by holding sufficient capital.

2.14.While different stakeholders have different investment strategies, systematically taking uncompensated risks does not create value. The companycan aim to stay clear of the following strategies:

• Holding a concentrated portfolio – this increases risk but not necessarily return.
• Frequent trading – trading always increases costs. These costs are certain, while additional returns from higher trading activity are uncertain.
• Investing in instruments with complex and opaque risk and return characteristics, such as highly leveraged structured credit products.

2.15.In the long term, certain risk taking provides extra returns (market return, also called ‘Beta’) Some investors can achieve extra, skill-based returns (‘Alpha’) on top of the market return (’Beta’) that their strategic asset allocation would provide.

2.16.In capital markets financial market prices generally adjust quickly to new information and so skill-based returns are uncommon and unpredictable. Also, for an Insurance Company that strives to generate value for its shareholders, an Alpha that is small relative to its total investment portfolio can still be significant relative to its shareholder’s equity. Therefore, the company has to be realistic about its own skills and that of their asset managers as only a small proportion of investment returns can be generally expected to be generated this way.

2.17.Investment Management has the objective to have a clear and consistent strategy focusing its organization on economic value creation. To maximize economic value creation, Investment Board Committee should manage investment risks relative to insurance liabilities and takes into account existing leverage of the investment portfolio versus shareholders’ equity.

2.18.Investment Management focuses on generating superior risk-adjusted returns based on selected investment risk level. In optimizing returns, Investment Management separately targets three sources of return. The risk free return is the predominant driver of return, followed by the market risk premium (Beta) and skill-based returns (Alpha).

2.19.The ambition for Investment Management should be crystal clear in its objectives– to strive to be the benchmark in insurance investment management. The challenge for the team in achieving this ambition is to explore and exploit continuously new opportunities and improve its investment and business strategy. Itshould be recognized that without continuous enhancement through sustainable innovation, no strategy can be successful over the long term to generate economic value to the Company’s policyholders and shareholders.

3.Other Main Tenants of Investment Strategy

3.1.As an Insurance Company that underwrites short term and long term insurance products, it needs to maintain a conservative posture that ensures that investments are sound enough to withstand adverse market conditions and meet the expectations of investors, rating agencies and regulators. This explains why principal preservation is the most important overall portfolio objective. Total return based on risk adjusted basis is the second most important objective of the portfolio.

3.2.Overreliance on fixed deposits and other interest-bearing instruments is avoided as the current situation of very low yields can materially reduce investment income. Even in a rapidly rising interest rate environment, the high rates pressurize asset values, capital levels and, if driven by inflation, cause adverse development in reserves.

3.3.Principal preservation is necessary to ensure that the Company withstand adverse market conditions while still meeting the expectations of rating agencies and regulators. Yet as per part of contingency planning, volatile and uneven financial markets as well as a low interest rate environment can made it difficult to generate a sufficient total return on Company’s portfolios that can add to existing financial cushions and satisfy investors. Lower investment returns can make it necessary for the Company to write its insurance business at higher returns, a reality that requires further discipline in insurance product pricing.

3.4.To cope with these potential market sensitivities, contingency strategies should be developed to navigate these risks that include different asset and liability matching choices, following a slightly more aggressive investment strategy, and outsourcing management of asset classes to benefit from specialized strategies and expertise. The portion of investment assets in equities and cash which can be liquidated to satisfy liquidity obligations. These contingency funding strategies have to be developed with a dual goal of targeting higher returns and maintaining appropriate levels of risk that will satisfy a broad constituency that includes investors, rating agencies and regulators.

3.5.The Companyshould follow the following guidelines for its liquidity requirements:

• To cover liability of Technical Provisions without Reinsurance recoveries,the company should invest in assets as appropriate to the nature and duration of its insurance liabilities;
• Investment decisions are in the best interest of all policyholders and beneficiaries; and
• Taking into account any policy objectives disclosed by the Company.

3.6.To keep this objective, investments can be made in liquid assets such as:

• cash and cash-equivalent instruments;
• time deposits;
• readily tradable securities;
• shares in publicly listed companies;
• Liquid corporate or sovereign bonds.

3.7.Funds for at least 3 times the monthly average cash outflow must be kept in above mentioned class of assets.

3.8.Matching is the process of constructing an investment portfolio which replicates the timing and amounts of future liability outgo. If such a portfolio exists, then the Insurance Company can have a reasonable expectation that their invested assets will be sufficient to meet their obligations.

3.9.The key areas of liability outgo uncertainty to consider are:

• Timing of payments
• Nature of payments (inflation linked, random nature)
• Currency of payment

3.10.Duration matching should be utilized for matching assets to liabilities as this ensures that assets are as sensitive to movements in interest rate as liabilities. General insurance liabilities are matched on a pool of homogenous policies that have similar claim frequency and severitydistributions and loss payment pattern. From the loss payment pattern, expected total claim amounts and cashflows are generated to arrive at duration figures for liabilities.

3.11.Duration for assets is calculated from the Modified Macualay method. TheModified Macaulay durationcalculates the weighted average time before an asset holder would receive the asset's cash flows sufficient to cover the price at which the asset was bought or sold.

3.12.To contain operational issues, operational policies for the implementation of the investment strategy should include:

• Identification of who is authorised to undertake asset transactions;
• Any restrictions on portfolio managers, for example, risk limits within the overall investment policy;
• The selection and use of brokers;
• Details of custodial arrangements;
• The methodology and frequency of the performance measurement and analysis;
• The agreed form and frequency of transaction reporting; and
• In the case of outsourcing, a contract setting out the policies and procedures;

3.13.Under investment guidelines, the company should set out a multi-asset or a balanced mandate detailing requirements of required return, risk acceptance level, time horizon, and proposed asset allocation, for example, of 60% and 40% into sukuks and shariah-compliant equities (which should be periodically reviewed).

3.14.Limitation such as maximum permissible exposure and minimum credit rating levels should be applied along with restrictions such as no borrowing permissible, shariah compliant investment and prohibition of derivatives usage except to hedge currency and/or related risks where necessary. The details are as follows:

• Exposure of deposits in a single bank should not exceed 25% of cash and money market portfolio,
• Exposure of single sukuk issue should not exceed 15% in terms of face value at the time of placement and should be contained within 15% after purchase - not applicable on issues by UAE, GCC governments and central banks,
• At no time total exposure should exceed 25% to a single issuer of sukuk in terms of face -value and be rectified if limit is breached - again not applicable on issues by UAE, GCC governments and central banks,
• Minimum credit rating limit of 'BBB-' of S&P ratings or equivalent but not applicable on ratings of sukuks issued by UAE, GCC governments and central banks,
• Exposure to unlisted equities should not exceed 20% of the equity portfolio,
• Exposure to a single equity should not exceed 15% of the equity portfolio at the time of purchase,
• Securities should be analyzed and corrective measures be taken if the fair value falls by 10% of the acquisition costs.

3.15.The company must set in place Strategy & Follow Up committee that reviews matters relating to investment management in case of non-compliance to the mandate.

3.16.The overall investment strategy adopted should be geared towards maintaining liquid investments such as cash and bank balances (including deposits) for short-term needs of liquidity given the nature of the main lines of business. Furthermore, investments in for example, sukuks and listed equities through an asset manager and in unlisted equities and property can help augment investment returns to the company.

3.17.Main risk exposures lie with the outsourced asset manager who may be adopting various tactical positions to ameliorate investment returns. Secondly, term deposit investments are rolled over at maturity that may lead to low investment returns due to falling deposit rates.

3.18.The Strategy & Follow Up Committee of the Board should review the performance of the asset manager quarterly. The asset manager usually makes a presentation to the committee of performance and makes recommendations as to the strategy for the next quarter. The recommendations are discussed and decisions made. The manager’s performance should be measured against a benchmark (Islamic S&P for the region).

ALM Strategic Review

3.19.Asset-Liability Management is a key function in insurance investment management. Insurers’ balance sheets are dominated by Group investments on the asset side and reserves for future claims and benefits on the liability side (ignoring unit linked investments which have identical offsetting liabilities). So, relative changes in value of Group investments relative to insurance liabilities can have a significant impact on shareholders’ equity. As a result, assets must be held not just to cover the expected claims but also unexpected, larger claims and be able to absorb adverse results from any asset-liability mismatch.

3.20.The ALM process can be summarized as follows:

Step1: investment objectives and constraints

3.21.This is the most important step of the process. Determining investment objectives and constraints is an iterative process. We often revisit this stage as we gain more insight and develop a greater understanding of a portfolio’s risk and return attributes under different scenarios. Importantly, we also analyze the trade-offs of various customized constraints.