30. Investment

Question 1

Principle of investment

Answer 1

• A company should select investments that are appropriate to the nature, term, currency of the liabilities
• The investments should also be selected to maximise the overall return on the assets, where overall return includes investment income and capital gains
• The extent to which the first point may be departed from to meet the second point will depend, inter alia, on the extent of the company’s free assets and the company’s appetite for risk

The company should invest so as to maximise overall return on assets, subject to risk taken on being within the financial resources available to it (free assets).

Question 2

Regulator can affect the assets held by applying controls

Answer 2

• inadmissible versus allowable assets
• restrictions on the type of assets that can be held or used to demonstrate solvency
• restrictions on exposure to single counterparties
• requirement that certain assets are held e.g. government bonds
• restrictions on matching:
  o requirement to match by currency
  o limit on the extent of mismatching
  o requirement to hold a mismatching reserve
• restrictions on the valuation method or valuations assumptions used regarding the assets invested in
• restrictions/requirements on the custodianship of assets
• security classes such as derivatives may not be allowed
• there may be regulations around the investment fees
• restrictions on international investments

Question 3

Steps in developing an appropriate investment strategy using ALM techniques

Answer 3

Model-office approach

1. Allocate free assets to support assets underlying reserves
2. Perform asset-liability projections for the end of each year of projection, compare total assets against reserves
   - for assets, stochastic investment models may be incorporated to project future investment income and changes in capital values
   - inflation rate models may be used to project future expenses on the liability side
3. Check the excess of assets over liabilities - should exceed statutory solvency capital (e.g. twice the statutory requirement) for the entire projection period, for most of the runs (say 99.5%)
4. Calculate measure of aggregate profitability
5. Repeat 2-4 assuming different (more or less risk) investment strategies until the target probability of insolvency is achieved
6. Identify which of the possible strategies, having the same insolvency risk, produces highest profitability

Weaknesses of the approach
- results only as valid as the model and parameterisation of the model
- only certain free assets are considered
- statutory SCR may not be constant

Question 4

Elements that may be varied in testing proposed investment strategies

Answer 4

1. The riskiness of the investment strategy
2. Level of free assets allocated to support strategy
3. Required probability of insolvency

Question 5

Ways to make investment strategy riskier

Answer 5

For assets backing liabilities - increase mismatch
- reduce of amount of matching by nature
- reduce of amount of matching term
- reduce of amount of matching by currency

Looking at assets in isolation
- increase duration

In both cases
- move from govt to corporate bonds
- lower credit rating
- equities: move to another sector

Question 6

Asset valuation

Answer 6

For short-term liabilities, like PMI
- value backing assets at market price

For long-term liabilities, LTCI, CI
- discounted cash-flow approach, returns are to be discounted on basis consistent with liability
- market value

Purpose of valuation will have influence on the method used