What are the main Principles of Investment?

What are the main Principles of Investment?

The canons of investment are safety, profitability, liquidity, diversification and increasing of life business.

1. Safety:

The securities in which the fund of insurer is to be invested should never at any time fall in their face values; otherwise the liability will be more than its corresponding assets.

The primary purpose of investment is not to earn maximum profit but to maintain a complete security. Therefore, speculative investments involving possibilities of large profits of large losses are not suitable for life insurance funds.

On account of trusteeship status, the insurer should invest the funds only in sound channels. Security of principal amount is more important consideration. Therefore, in India, the investment regulations are made whereby the life insurer is required to invest at least 50 per cent of his controlled funds in Government Securities.

Safety includes safety of principal amount and interest, thereon. It means that the principal and interest must not fall, below the expected level at any time. This principle is the keystone of investment.

2. Profitability :

The insurer must earn at least the assumed rate of interest otherwise he will suffer loss. The investment, so, should be made in such securities which yield the highest return consistent with the principle of safety.

The insurer can reduce his future premiums by earning higher interest and thus will be able to increase its business. It has been realized that the safety and the profitability principles are opposite to each other.

The safest securities earn little profit and vice-versa is also true. Therefore, the investment department has to establish a proper balance between safety and profitably. However, there are certain securities where the safety and the profitability principles are fully observed. Gilt- Edge-Securities, National-Defence Securities are some of the examples of such securities.

Insurance Principles and Practice:

A very large portion of funds may be invested in safe-securities which might yield at least assumed rate of interest while the other small portion may be invested in profitable securities guaranteeing, aft-least safety of principal amounts. In addition, an investment fluctuation funds may also be created to meet any possible losses on account of fluctuations in return.

In profitability reasonable rate of return with regularity and stability of income is essential. The second factor to be considered is no fluctuation in capital and lesser expenses of investments. The third factor i.e., taxation is also important because unfavorable taxation may reduce the net income of the insurer.

3. Liquidity :

It represents convertibility of investments into cash without undue loss of capital. The principle is essential because of immediate requirement of money for payment of claims.

However, there is no higher chance of maximum outflow at any time because the maturity, unlike the bank withdrawal, may not fall within a short period. The claims are, generally, following a set-trend on the maturity and death experience.

A rough estimation can be made of the payments of claims, surrender values, policy loans and regular expenses’ Funds’ should be invested according to the requirements of the insurers, i.e.. Investments are so made that the maturities will occur at intervals adjusted to meet the needs of maturity obligations.

For meeting the daily outflow of funds, it is not essential to keep maximum amount in cash or in readily convertible securities because a vast inflow of cash is observed in form of premium return on investment and sale of securities.

For the established and financially stronger insurers, the liquidity is not much essential. Moreover, the insurer can insert a clause of delay in payment for a specific period.

The principle of liquidity is against the principle of profitability because the idle cash will earn nothing and invested cash will have no liquidity.

4. Diversification :

Diversification of investment may mean spreading investment over different channels. The spreading may take place in the following manners.

(a) Diversification on the basis of geographical distribution.

(b) Distribution of the portfolio over the different economic enterprises of the country, political changes and time.

(c) Diversification may be according to number of investment in a security, maturity of security and duration of security.

(d) The distribution of funds according to industries, firms and sectors.

The diversification provides maximum security with high yield and better liquidity provided the diversification was done taking into account of all these factors. Do not invest all the funds at one place in an industry, in a security and for a period of maturity.

Investments should spread over the widest possible range to minimise unfavorable consideration and to gain favorable advantages. Under diversification, the law of average reduces the losses to minimum.

5. Increasing of Life Business :

Investments should also be made in those sectors which are going to benefit the business in the return. Naturally, the social objective principle helps in increasing the business. For example, the life funds, if utilised to finance the schemes of housing, sanitation, medical and education, it will go a greater way to lower the mortality and to increase the standard of people.

Decreased mortality and increased income cause more business to insurer because the lower mortality tends to reduce the rate of premium which increases the business. Higher income induces person to get more policies.

Principles of investments as laid by Mr. A. H. Bailey:

Mr. A. H. Bailey was actuary of the London Assurance Corporation. He contributed a paper in 1862, which was published in Journal of Institute of Actuaries, Vol. X. The principles are commonly known as ‘Bailey’s Canons’ which remain as much applicable to insurance business today as they were in 1862.

However, their mode of application can be changed with the changing conditions. His principles of investment are summarised as below:

(i) That the first consideration should invariably be the security of the capital.

(ii) That the highest practicable rote of interest be obtained, but that this principle should always be subordinate to the previous one, i.e., the security of capital.

(iii) That a small proportion of the total funds (the amount varying according to the individual circumstances of each case) should be held in readily convertible securities for the payment of current claims.

(iv) That the remaining and much larger proportion may be safely invested in securities that are not readily convertible.

(v) That as far as possible the capital should be employed to aid the life insurance business.