Ch 33: Investment

Question 1

SYSTEM T

Answer 1

• Security
• Yield
• Spread
• Term
• Expenses
• Marketability
• Tax

Question 2

Principles of investment

Answer 2

• In order to minimise risk, company should select investments that are appropriate to the nature, term and currency of the liabilities
• The investments should be selected so as to maximise the overall return on assets where overall return includes both investment income and capital gains
• Extent to which the appropriate investments may be mismatched to maximise return will depend on free assets

Question 3

Determining optimal investment strat (8 steps)

Answer 3

• Define outcome to be measured and time horizon
  * E.g. probability of insolvency
• Input assumptions for liabilities and assets are required:
  * Assumptions should be best estimate and should not include margins
  * For liabilities: demographic assumptions (mortality…) and bonus philosophy
  * For assets: expected returns, variances, correlations and tax rates
• Assets and liablities are projected together into the future:
  * Assets:
  * Starting point is current split of assets
  * Liabilities:
  * Liability cashflow projection should include all policies or model points of existing business and new business
  * For each model point future probability-weighted cashflows are calculated (e.g. for decrements including deaths, lapses)
  * Future bonus additions will be based on projected asset returns and on modelled algorithm that mirrors company’s bonus philosophy
  * Expenses are projected by linking these to projected inflation rates
• Model should produce net cashflows, assets, liabilities, solvency requirements and thus solvency level for each time period up to the time horizon
• Number of simulations must be high enough to enable probabilities of extreme events to be measured
• Company is able to measure probability of various outcomes against its requirements (probability of insolvency associated with specific investment strategy and bonus philosophy
  * Requiremnt could be that assets exceeds liabilities plus any solvency margin for entire projection period 99% of model runs)
• If solvency probability appears to high, company should consider changes to its investment strategy.
• calculate some measure of aggregate profitability;
• repeat assuming different (more or less risky) investment strategies until the target probability of insolvency is achieved; and
• identify which of the possible strategies, having equal insolvency risk, produce the highest profitability.

Question 4

Factors to consider when assessing appropriateness of investment strategy (11)

Answer 4

• Nature, term, currency and uncertainty of the liabilities (benefits and expenses)
  * Consider most suitable assets that match the liabilities
  * Uncertainty gives rise to need for liquidity
  * For term, consider reinvestment risk and inflation exposure
• Constraints on investment strategy:
  * Size of assets
  * Tax - differences oin tax treatment of various assets may influence preference of some assets above others
  * Statutory restrictions on how to invest
  * Solvency requirements
• For with-profits consider policyholder expectations for future bonuses
• Institutional objectives
• Competitors’ investment strategy
• Company’s free assets
• Company’s risk appetite
• Availability of assets