16 - Investment principles and asset-liability modelling Flashcards

1
Q

hat is the main focus of asset-liability modelling (ALM)?

A

The main focus of ALM is an important fundamental method for setting a strategy for an asset base which has an associated liability. As a method, ALM is applicable to more than just medical schemes and retirement funds, involving a deep understanding of the ALM process and objectives to inform setting an investment strategy.

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2
Q

What are the fundamental principles of investment for benefit arrangements?

A

The fundamental principles of investment for benefit arrangements are:
* An investor, whether a retirement fund, health insurer, or medical scheme, should select investments that are appropriate to the nature, including uncertainty, term, and currency of its liabilities.
* The investments should also be selected so as to maximise the overall return on the assets, after taxes and expenses, where overall return includes both investment income and capital gains.
* The extent to which (a) may be departed from in order to meet (b) will depend, inter alia, on the extent of the investor’s free assets, or investor’s surplus, and their appetite for risk.

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3
Q

What are some of the key characteristics by which asset classes are typically considered according to the provided material?

A

Asset classes are typically considered according to the following characteristics:
* Expected return profile
* Security, and volatility of market value
* Marketability
* Expenses
* Term
* Currency
* Tax
* Regulatory or supervisory constraints

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4
Q

Describe nominal (or conventional) government bonds and highlight a key point regarding their use in a matching strategy.

A

Nominal government bonds are loan stock issued and guaranteed by governments, usually with a fixed coupon or interest rate. Generally, nominal bonds have a predictable nominal income to meet interest payments and the full amount of debt at redemption. A key point is that the return is variable if the bonds are not held to redemption, making this an important consideration when using bonds in a matching strategy.

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5
Q

How do index-linked government bonds differ from nominal government bonds?

A

Index-linked government bonds differ from nominal bonds in that their coupon payments and/or capital redemption will be referenced to some index or value, typically local price inflation. Governments normally issue more nominal bonds than index-linked bonds, and the secondary market in index-linked bonds tends to be smaller.

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6
Q

What is the primary source of return for equities, and what is a characteristic of equity market volatility?

A

Returns on equities are made up of income, that is dividends, and return on capital and are generally real in nature. Returns are not guaranteed, and equity holders receive the balance of any profits only after debt costs are paid. A key characteristic of equity market volatility is that both the income and capital value of equities are at risk if the company performs badly or becomes unprofitable, and equity market pricing is volatile, which can be a problem even when holding the asset for long-term income.

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7
Q

Briefly describe the nature of property as an asset class.

A

Property normally refers to land owned directly, also referred to as unlisted property, or through the listed equity market. Direct property tends to be a niche asset class with very low levels of liquidity. Listed property companies available through the listed equity market have similar liquidity to equities, as discussed above.

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8
Q

What is the general investment characteristic of short-term government bonds providing a guaranteed nominal value and income over the short term?

A

Investment in short-term government bonds providing a guaranteed nominal value and income over the short term generally presents different risk characteristics, for example, lower returns compared to assets with less certainty.

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9
Q

What is the traditional view regarding the increasing level of return to investors from government bonds, index-linked government bonds, and equities?

A

The traditional view is that these three types of assets present increasing levels of risk to investors. The traditional view is that because of this, investors should expect a higher return from equities than from government bonds and cash. Historical evidence tends to support this hypothesis, but only if the assets are held over very long periods of time.

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10
Q

Define segregated portfolios as a legal structure for investment.

A

Segregated portfolios are pools of assets that are held specifically for the investor in its own portfolio and in its name. They are segregated from the other assets managed by the investment manager and are typically economical for very large investors such as large retirement funds. The assets are held in the name of the investor.

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11
Q

Explain the concept of perfect matching in asset-liability management.

A

Perfect matching is a theoretical concept where the assets and liabilities are perfectly matched. This implies that if it is possible to buy assets whose proceeds arise from the assets, as they occur, then the assets and liabilities would be perfectly matched and there would be no investment risk.

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12
Q

Define discounted mean term in the context of discussing liabilities.

A

The discounted mean term of an asset or liability is defined as the weighted sum of the terms of the payments, where the weight attributed to each term is the present value of the payment at that term.

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13
Q

What is the aim of immunisation as a technique in asset-liability management?

A

The aim of immunisation is to protect the investor from changes in future interest rates.

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14
Q

State the conditions under which a liability and asset position will be immunised.

A

A liability and asset position will be immunised if:
* The present values of the liability outflow and the asset proceeds are equal.
* The discounted mean term of the liability outflow and the asset proceeds are equal.

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15
Q

What are stochastic models and why are they widely used in ALMs?

A

Stochastic models are widely used to value assets as well as liabilities, especially those relating to options and guarantees. A stochastic model of the liabilities can be used to establish a replicating portfolio of assets to hedge the liability position under different scenarios. They are widely used because they examine both the assets and liabilities together through a stochastic model.

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16
Q

Briefly outline the ALM process.

A

The ALM process involves the following steps:
1. Specify the objectives.
1. Decide on the time horizon for the simulation.
1. Collect and prepare data.
1. Perform a large number of simulations and record each result.
1. Use the results to measure the achievement of the objectives under different scenarios.
1. Vary the item being optimised, repeating the simulation and measurement process each time, recording the results.
1. Use the results to compile alternative options or strategies, in relation to the objectives of the modelling exercise.
1. Explain and discuss the results with the client, being careful to identify the salient results and strategies.
1. Test these particular strategies more thoroughly, for example, under different assumptions, in order to check that they remain reasonable.
1. Give final advice, helping the client to reach a decision.

17
Q

What is a key limitation to consider regarding the time horizon used in ALM projections?

A

A key limitation is that the time horizon for the projections is important in determining the credibility of the results produced. Some models have been calibrated assuming that they will be biased over a particular time horizon, often quite a long period. Clearly, these will not be appropriate for measuring risk over the short term.

18
Q

Why are many simulations required for a reliable estimate in ALM?

A

Many simulations are required for a reliable estimate because the number of simulations necessary for a reliable estimate depends on what is being investigated. For example, for the funding level for a given investment strategy may be quite small (e.g., 100 may be enough), however, to investigate the 99th percentile with any accuracy will take thousands of simulations.

19
Q

What is a crucial point to remember when interpreting the results of ALM models calibrated to general data?

A

An important point is that models calibrated to general data cannot be expected to give reliable results in the tails. Standard economic market relationships often break down, and in the extreme tails, market themselves may no longer even function.

20
Q

Describe the “random walk” as a commonly used type of asset price process in ALMs.

A

The “random walk” is the simplest model, assuming that asset values move up and down independently of past asset values. Typically, the moves may be taken to be from a LogNormal distribution. This model assumes that future returns are statistically independent of past returns.

21
Q

Explain the “arbitrage-free models” used for asset price modelling in ALMs.

A

Arbitrage-free models are models of the yield curve that are often divided between arbitrage-free and statistical models. Arbitrage-free models generate an asset-pricing theory to impose conditions on the yield curve that are necessary or ensure that there is no arbitrage between different bonds, either now or in the future. Other yield-curve models, such as those based on market segmentation hypothesis or the term preference arbitrage, together with market arbitrage, allow more realistic yield curve dynamics.

22
Q

What are the typical outputs that can be produced from an ALM process?

A

Typical outputs from an ALM process include:
* For any given investment policy, statistics, such as mean, standard deviation, percentiles, on the distribution of possible future valuation results at the horizon time. It is possible to express these valuation results in many forms, namely funding level, contribution rate (CR), solvency level, reported pension cost, etc..
* Statistics on the distribution of net cashflow (asset income plus contributions less benefit and expenses outgo – from the fund for each year during the period of assessment to assess the likelihood of having to realise assets, possibly on unfavourable terms.
* Results under alternative sets of assumptions as input parameters to the stochastic model.

23
Q

What is the importance of sensitivity to assumptions and scenario analysis in ALM?

A

The sensitivity of the results to a change in any of the assumptions should be explored as this demonstrates how vulnerable the success of a strategy is to a change in conditions. Sensitivity analysis may reveal that one of the possible strategies appears preferable in one scenario, while another appears preferable in a different scenario. Scenario analysis, where specific sets of conditions are changed, is also useful to understand how the results would behave under expected changes to the set of assumptions.

24
Q

What are some key considerations for the “importance of judgement” in the context of ALM?

A

It is extremely important not to overstate the power of an ALM, as it is an oversimplification of the real world. The importance of judgement lies in:
* The views of a disparate group of stakeholders or their representatives, including trustees, management, advisors, who will not all necessarily agree.
* The views of the sponsor/employer of a retirement fund or management of a medical scheme, especially on the direction of the business or future employee policy.
* The need to choose policies that appear sensible in a world where there is uncertainty about the choice of stochastic investment model and the choice of input parameters for that model.
* The need to bear in mind that policies that are the most appropriate on an ongoing basis may need to be adjusted to reflect the impact of changing regulations or other externalities.
* Practical factors, for example, a large property holding that cannot be disposed of quickly without incurring unacceptable costs and therefore needs to remain part of the investment strategy, even if the model outcome is to exclude it.

25
Q

For defined benefit (DB) funds, what is the objective or purpose of using ALM?

A

For DB funds, the objective of ALM is often to assess the ability of the assets to be sufficient to cut future contributions, or increase future benefits, by providing discretionary pension increases. ALM can also be used for designing a fund, if such projections are performed for a variety of different financing strategies, the relative risk of these strategies can be assessed, as can the relative rewards.

26
Q

What are some alternative objectives that might be related to ALM for a DB fund?

A

Alternative objectives related to ALM for a DB fund include:
* The ongoing funding level.
* Any statutory minimum funding level.
* The probability of insolvency on a discontinuance basis.
* The annual increases provided to pensioners.

27
Q

What are some key aspects of the nature and term of a DB fund’s liabilities that are important for ALM?

A

Key aspects of a DB fund’s liabilities include:
* The fund’s benefit structure.
* The nature of the fund and its current and future membership profile, for example whether the fund is pensioner only or open to new entrants.
* The fund’s demographics, such as member increase.
* Future interest rates and inflation.
* Future salary increases. DB fund liabilities tend to be very long term in nature, depending on the membership profile of the fund.

28
Q

How can demographic assumptions impact the modelling of DB fund liabilities?

A

Demographic assumptions are supplemented by explicit assumptions about new entrants, together with the proportions of pensioners taking commutation, deferred pensioners taking transfer values, and active or deferred members taking early retirement. These are all assumptions affecting the timing of cashflows, which are often ignored in a cashflow projection process. In theory, demographic assumptions such as the level of new entrants and withdrawals could also be modelled stochastically.

29
Q

Describe the Lee-Carter model as a popular type of demographic model.

A

The Lee-Carter model assumes that future mortality probabilities follow a LogNormal distribution, with an expected value based on a long-term trend. In the simplest version of the model, changes in mortality probabilities at different ages are perfectly correlated.

30
Q

For defined contribution (DC) retirement funds, what is the primary goal when using ALM?

A

In the DC fund context, ALM models can be used to test the consequences of members’ different investment strategies. Given that DC funds typically have a default investment strategy and some limited investment portfolios for individual member choice, the long-term performance objective and risk parameters will be modelled to test their validity and efficacy against these long-term performance objective and risk parameters.

31
Q

What are the main liability outgoings for health insurers and medical schemes?

A

The main liability outgoings for health insurers and medical schemes consist of:
* Benefit payments
* Expense outgo
* Premium outgo, for health insurance products, or contribution, for medical scheme products, income.

32
Q

Describe “guaranteed in monetary terms” as a type of benefit payment for health insurers.

A

Guaranteed in monetary terms consists of benefit payments where the amount payable is specified in the contract in monetary terms.

33
Q

What is “indemnity” as it relates to benefit payments in health insurance?

A

Indemnity refers to the fact that the amount paid in respect of the policyholder is dependent on the costs incurred in receiving treatment covered by the policy.

34
Q

How does the expense outgo tend to behave over time for health insurers and medical schemes?

A

Expense payments tend to increase over time. The rate of change in a price, or earnings, index, but for investment purposes it is adequate to treat it as being so. Hence, they can be included with benefit payments guaranteed in terms of an index of prices or similar.

35
Q

What is a key challenge in perfectly matching assets with liabilities for an insurer or medical scheme?

A

In most cases it is almost impossible in practice to find assets whose proceeds exactly match the expected liability outgo. The terms of available fixed-interest securities, typically nominal and index-linked government bonds, may be shorter than the corresponding liabilities.

36
Q

Explain the concept of “investment-linked” benefits in the context of health or medical schemes.

A

Investment-linked benefits are guaranteed in the sense that their value can be determined at any time in accordance with a definite formula based on the value of a specified fund of assets, or investment index. The insurer can avoid any investment matching problems by investing in the same assets as used to determine the benefits.

37
Q

What are “free assets” in the context of a health insurer or medical scheme?

A

The existence of free assets in a health insurer / medical scheme means that it can depart from the matching strategies outlined above so as to improve the overall return on its assets. This will ultimately benefit its policyholders / members through lower premiums / contribution rates, and shareholders, if any in the case of a health insurer, through higher dividends.

38
Q

What is a final point to note regarding the appropriate matching strategy for the free assets themselves?

A

They do lack liabilities; they form part of the capital or funds of the insurer / scheme, so there is an obligation to provide a return to the providers of that capital or those funds. Hence, taking their investment risk appetite into account, hence would expect investment in higher-yielding assets to help meet this obligation.

39
Q

What is a key consideration regarding the currency of assets and liabilities for health insurers and medical schemes?

A

Health insurers’ and medical schemes’ liabilities are usually based in local currency terms. However, certain aspects, such as pharmaceuticals and medical equipment, are often imported from international markets, so there is some need to consider the exposure to exchange rate fluctuations.
This set of flashcards provides a comprehensive overview of the key concepts discussed in the source material relevant to investment principles and asset-liability modelling for actuarial exams revision. You can use these as a starting point and create more detailed cards for specific areas as needed.