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I be examined respectively in the non-life i the life sectors.
,Nature of Insurance Funds
An insurance fund, which can be used investment by an insurance undertaking, mes from two main sources: the policy
,lder liabilities and the capital base.
Policyholder Liabilities
Whether in the non-life sector or the life .ctor, the portion representing policyholder abilities fonus the majority of an insurance llld. These policyholder liabilities are owed y insurance undertakings to their policy
olders, and are prepared to meet future laims from either the policyholders or their ,eneficiaries. Generally speaking, this kind of nsurance funds can be perceived as thers' imds" because they have to be reserved for )olicyholders rather than being owned by the nsurance undertakings.
(l) Non-life Insurance
In the non-life insurance sector, policy
holder liabilities consist of three major types of technical reserves, namely, unearned premium reserves, loss reserves, and volun
tary reserves.
I) Unearned premium reserves
Unearned premium reserves, which equal the unearned portion of the gross premiums of
all outstanding policies at the time of valuation, arises because most insurance premiums are paid by policyholders in advance.
2) Loss reserves
"Loss reserves measures the insurer estimated liability for unpaid claims and settlement expenses as of the valuation date.
It includes the amount of liability for the claims reported and adjusted but not yet paid, the claims filed but not yet adjusted, and the claims incurred but not yet reported (IBNR)".46
3) Voluntary reserves
Unlike the previous two types of re
serves which are required by law, voluntary reserves are voluntarily lodged by insurance undertakings. In the non-life insurance sector, equalization reserves or claim fluctuation reserves, which are used to counter the fluct
uation of loss experience, are good examples.
In some countries, equalization reserves, which usually bear some relationship to the size of policyholder liabilities, are required by legislation. This kind of reserves can be perceived as "a form of quasi-capital, hav
ing a financial character between that of policyholder liabilities and the capital base."47
With regard to the funds representing these reserves, a reasonable non-life insurance undertaking, will have a significant proportion
46) Mehr R.L, Cammack E. and Rose T., Principles ofInsurance, 8th ed. (1985) p693.
47) Dickinson G.M., supra note 42, p212.
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/
of their investments with a fairly high degree of liquidity. The reason is that the level of the future claim payments in non-life insurance can not be accurately predicted, and therefore an non-life insurer may encounter extraor
dinary underwriting fluctuation, both in terms of timing and in the amounts of settlement.
Under such circumstances, adequate amounts of cash need to be available because either it must indemnify the losses promptly or its "net cash flows"48 may be breached due to cata
strophe or loss accumulation.
(2) Life insurance
The most important reserve for policy
holder liabilities of an life insurer is the policy reserve. "It measures the amount which together with future net valuation premiums and interest will produce the exact amount needed to pay all policy obligations as they become due if the mortality experienced and interest earned precisely as assumed. "49
Other kinds of reserves for policyholder liabilities include the reserves for the claims reported but not yet paid, plus those incurred but not yet reported. As life insurance claims are reported and settled promptly, these
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reserves are of secondary importance and relatively small.50
In general, the terms of policyholder liabilities in the life insurance sector have a much longer duration than those in non-life insurance, particularly in the business which relates to long-term saving and retirement provision. This means that the time horizon for investing policyholder funds can be much longer than that for non-life insurance. On the other hand, the expectation of cash flows is much more stable because premiums inflows can depend on a weighted average of past sales and claims and other cash outflows can be more actuarially predictable. In such a scenario, life insurance companies do not normally have a major concern with pre
cautionary liquidity within investment port
folios. 51
In some circumstances, however, there can be a concern for precautionary liquidity arising from other promises that they have made to their policyholders. This can arise if the insurance company has incorporated high guaranteed "surrender values"52 into its con
tract, especially if there is also an option of
48) Net cash flow, which represents the difference between inflows (premium, investment returns and other incomes) and outflows (claims, expenses and other outgoes) of an insurance undertaking, is normally the insurer's first line of defense against the claims.
49) Mehr R.I., Cammack E. and Rose T., supra note 46, p695.
50) Ibid., p699.
51) Dickinson G.M., supra note 42, p215.
52) The saving component of life insurance policies, called non-forfeiture value, is available to policyholders who want to surrender their policies. In such an event, the non-forfeiture value
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1\Xj:.+ = F.I
~f*~~JlIlzc!{~~ff,t~t~~JlIl1JiID"policy-loanst!53.
In recent years there has been a rapid growth of "linked-lifet!54 contracts in a num
ber of developed markets. Such contracts possess quite different characteristics from traditional life insurance contracts. As a matter of fact, insurance companies which supply such life insurance products face no investment risks at all because policyholders carry all of the risks themselves.
2. Capital Base
As discussed earlier, insurance capital represents the total net worth, i.e. the di
fference between assets and policyholder liabilities, of an insurance undertaking. In terms of fund source, the capital base of insurance funds can be termed as "own- funds" because it is owned by an insurance undertaking itself rather than other legal entities.
It should be noted that, since the capital base is the asset deducted by policyholder liabilities, its value will depend critically on the valuation basis used to measure assets and policyholder liabilities. In most countries, the
statutory capital requirements provide that assets and policyholder liabilities should be valued in a more conservative method than other businesses are.
Generally speaking, whether in the non
life sector or in the life sector, the capital base can be divided into two main items, minimum statutory capital and free capital. Minimum statutory capital is the level of capital requirement that an insurance company must maintain under local legislation to ensure minimum financial security. Free capital, on the other hand, is the amount in excess of the minimum statutory level.55
Considering the nature of a capital based insurance fund, the investment regulations for such a fund are less constrained and defensive than those for policyholder liabilities in most developed countries. They can be invested in financial assets that are expected to yield higher rates of return, even though they may possess more default and liquidity risk.
Nevertheless, the priority attached to earning a high rate of return needs to be considered because, as mentioned earlier, capital base
can be termed as surrender value.
53) Policyholders can use their policies, the nonforfeiture value, as a guarantee to borrow from their insurers an amount which can be equal to around surrender value.
54) Link-life insurance means that a life insurance policy is linked with an investment portfolio from which policyholders, not insurers, assume the investment risks. For example, in variable life insurance policies, insurers permit policyholders to distribute their premium and cash value among two or more investment portfolios. Regardless of the investment performance, the insurers guarantee the minimum death benefits, rather than the amount of cash value. See generally Williams C. A. Jr. and Heins R. M., Risk Management and Insurance, 6th ed.( 1989) McGraw-Hili, p540.
55) Dickinson G.M., supra note 42, p213.
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also concerns with the ultimate buffer against very large potential claims and serves to finance the long term growth of the business.