This historic development was caused by the sharp acceleration of inflation in the late 1970s and early 1980s and the attendant near tripling of interest rates between 1975 and 1982. Long-term investments in bonds and mortgages had dominated insurance portfolios as the counterpart to whole life policies, the main accumulation product. These investments, with an average maturity of roughly 20 years, turned out to leave the industry behind in terms of yield on the savings element of life insurance as market rates of interest adjusted to inflation. Large parts of the industry became noncompetitive in attracting funds and subject to heavy outflows through surrenders and policy loans as policyowners took their savings elsewhere.

Initially in self-defense but later as an aggressive sales tool, the industry developed universal life and other products to compete with the then higher current yields by passing investment yields directly through to policyowners, encouraging in turn a scramble for high-yield investments and competition for funds based on interest rates. The nature of insurance contracts makes it nearly impossible for an insurer to make major and significant changes instantaneously. Two significant tactics were utilized to speed up such adjustments: (1) the start-up of brand new subsidiary insurance companies with the entire portfolio invested at current yields and (2) the exchange of old, in-force policies with new contracts containing lower premiums and variable interest rates for policy loans.

Interest-rate-based competition survived the relatively short period of historically high yields, which ended by the early 1990s. The investment field is now dealing with the consequences. One of these consequences is the broadening of buyers� choices for insurance products and investment vehicles for the life insurance savings dollar. Another is an increase in the number of life companies that failed as sharpening competition cut into product margins and encouraged heightened investment risk-taking. Still another result is that annuities, with their highly visible yield link, have become more important than insurance in generating investable funds. The average maturity of the typical insurer�s portfolio has also been cut in half, to roughly 10 years, both to minimize the yield lag if accelerating inflation returns and to accommodate the escape clauses in their contracts that corporate and individual policyowners now demand in anticipation of resurgent high interest rates and high inflation rates.

On the more technical side of portfolio management, investment executives have had to learn and implement new technical and analytical skills. First and foremost, they have had to evaluate the liability characteristics of different insurance products with respect to a more detailed and complex set of risk classification categories to arrive at correct maturity and risk characteristics of the corresponding assets. One aspect of this process has been termed segmentation of the general account (grouping assets according to their risk characteristics and establishing criteria to maintain prescribed ratios of holdings in each of these categories). Second, the rising risk of policyowners� massive and instantaneous withdrawal of funds has required not only shorter asset maturities but also protective techniques (such as staggered maturities) and the increased use of liquid instruments (such as U.S. Treasury and agency securities). In addition, options, futures, and other partial offsets to a riskier environment have become routine among many companies. Finally, the search for inflation protection has led some companies into enlarged equity positions in the general account, mainly through the use of equity kickers, warrants, or similar devices attached to debt instruments.

The "financialization" of life insurance portfolios has created new problems for regulators, policyowners, and investors. Excess debt generated during the 1980s among corporations and commercial real estate interests was spurred to dangerous levels by the supercharged speculation by individual investors based on expectations of continued high levels of inflation. This was extensive among depository institutions such as savings and loan companies, but to a moderate degree also among competition-driven insurance companies. Consequently, insurance regulators backed off in the late 1980s and early 1990s from the liberalization in the early 1980s of the quantitative investment rules that had long been a characteristic of insurance laws. The trend in the early 1990s was in the opposite direction�toward detailed limitations on the insurer�s portfolio composition. Lowering the allowable proportion of low grade (junk) bonds is but one example. Substantial discretion�a prudent-man rule�continues to prevail for much of portfolio management.

As financial pressures increased through narrowing spreads on traditional insurance products, fierce competition in new product yields, and the rising cost of outside capital, commercial rating agencies entered the life insurance field for the first time in a serious and sustained manner. After the failures at Baldwin United and Charter Securities in the mid-1980s, ratings became important in the markets and to the companies. The negative publicity generated by a few major insurance company failures in the early 1990s (Executive Life, Mutual Benefit Life, Confederation Life) prompted both insurance agents and insurance consumers to increase their insistence on dealing only with insurers having the highest-quality ratings.

An interaction of regulators and rating agencies developed as each sought to generate early warnings for the public, policyowners, and investors. Much of the attention of both regulators and rating agencies was focused on the investment portfolio.

The overexuberance and debt overhang of the 1980s was especially apparent in rising mortgage delinquencies and a moderate rise in nonperforming bond holdings. The entire experience of failures and widespread writedowns led the insurance regulators toward broadened asset reserves effective in late 1992, careful calculation of investment factors within the risk-based capital standards that became effective in all states by the end of 1994, and development of a National Association of Insurance Commissioners (NAIC) Model Investment Law. The NAIC has tightened up its self-examination procedures to make sure that agreed-upon laws and regulations are actually enforced in each state.

Meanwhile, the search for new capital�simply to grow modestly or just to stay in business, quite apart from regulation�began to dominate industry thinking in the early 1990s. Traditional conservatism reasserted itself in all phases of insurance management. Nevertheless, two decades of rapid evolution have strengthened and broadened the investment function in many important ways. Investment officers have acquired a far greater knowledge of market instruments, are more flexible and adaptable in their use of instruments and techniques, participate more in insurance product development and marketing, and are wiser to the perils of the marketplace. Should the country�s economic performance improve in the second half of the 1990s, investment management is poised to take advantage of developing opportunities and, one hopes, will not forget the lessons of the 1980s.