Ch 33: Investment

Question 1

State the 3 main principles of investment for a life insurance company (5) and how can these investment principles be summarised (2)?

Answer 1

Principles of investment

1. To minimise risk, insurer should select investments that are appropriate to nature, term and currency of liabilities
2. Investments should be selected to maximise overall return on assets, where overall return includes both investment income and capital gains
3. The extent to which the ‘appropriate’ investments referred to above may be departed from to maximise overall return will depend, amongst other things, on
   
   1. extent of company’s free assets
   2. company’s risk appetite

Alternatively, principles of investment may be stated as

• company should invest so as to maximise overall return on assets,
• subject to risk taken on being within available financial resources

Question 2

List the 4 main asset classes in descending order of (likely) expected return (4)

Answer 2

Main assset classes in descending order of (likely) expected return

1. equities and property
2. corporate bonds
3. government bonds
4. cash and money market instruments

Question 3

What are the key characteristics according to which we consider and compare various asset classes? (7)

Which is the most important characteristic to consider, and what points do we need to bare in mind regarding this characteristic? (6)

Answer 3

We can consider asset types according to the following key “SYSTEM T” characteristics

1. Spread (volatility)
2. Yield (return)
3. Security
4. Term
5. Expenses
6. Marketability
7. Tax

Of the above characteristics, ‘yield/return’ is the most important, in particular

1. how much expected return will be
2. whether return is real vs nominal
3. split of return between income and capital gain
4. whether running yield sufficient for investors’ needs
5. variance of return
6. tax implications for return

Question 4

In addition to the highly important ‘investment return’ asset class characteristics, what 2 other factors are of key importance? (2)

Answer 4

1. Statutory constraints on insurer holding certain assets
2. Tax implications
   
   • tax reduces returns
   • tax regime may favour investment in particular assets
   • tax regime may favour income over capital gain (or vice versa)

Question 5

Government fixed interest bonds

Discuss characteristics (10)

Answer 5

1. Spread (volatility):
   
   • return not variable, unless not held to redemption, very important when considering matching issues
   • short term market value flactuations with market, eventual redemption unaffected by such fluctuation
2. Yield (return):
   
   • nominal
   • coupon yield similar to money market yield; may also be zero coupon, where running yield is zero, and all of return is capital gain through redemption value
3. Security:
   
   • very secure, most secure asset class other than cash
4. Term:
   
   • depends on market, typical 15 to 20 years
5. Expenses:
   
   • low dealing costs
6. Marketability:
   
   • most marketable and common asset type
7. Tax:

Question 6

Government index linked bonds

Discuss characteristics (9)

Answer 6

1. Spread (volatility)
   
   • return not variable, unless not held to redemption, very important when considering matching issue
   • short term market value flactuations with market, eventual redemption unaffected by such fluctuation
2. Yield (return)
   
   • payments defined in terms of index eg price inflation => impacts returns
3. Security
   
   • very secure, as with fixed interest gov bonds
4. Term
   
   • less variety than gov fixed interest bonds + smaller amounts issues
5. Expenses
   
   • probably low dealing costs, but more expensive than gov fixed interest, as less variety traded
6. Marketability
   
   • lower marketability than gov bonds, because of less variety/smaller amts
7. Tax

Question 7

Corporate fixed interest bonds

Discuss characteristics (9)

Answer 7

1. Spread (volatility)
   
   • non volatile return, if held to maturity
   • market value flactuates with markets, but less important if held to redemption
2. Yield (return)
   
   • higher return than government fixed interest bonds of same term
   • running yield similar to prevailing market interest rates for term concerned
3. Security
   
   • less secure than governemt bonds
   • can be a problem if issuing company not AAA rated
4. Term
   
   • terms similar to government bonds
5. Expenses
   
   • higher dealing
6. Marketability
   
   • lower marketability
7. Tax

Question 8

Equities

Discuss characteristics (13)

Answer 8

1. Spread (volatility)
   
   • volatile income/capital value
   • underlying company itself might go bakrupt/perform badly
   • volatility can be problematic even when holding the asset for long term income, because
     
     • may need to be valued to help demonstrate solvency and
     • when having to redeem it for much less than hoped
2. Yield (return)
   
   • returns (dividend) which would be expected to increase in real terms
   • market value of share also expected to increase in real terms
   • low running yields
3. Security
   
   • underlying company itself might go bakrupt/perform badly
4. Term
   
   • what is the term for an equity? well, can be held in perpituity
   • for matching purposes, discounted mean term is important measure of term, and it is finite for equities
5. Expenses
   
   • usually low dealing costs; depends on how developed market is
6. Marketability
   
   • highly marketable in some markets where equity investments is very developed, but there will also be almost unmarketable stocks
   • in other markets equity investment may not be an option because of the size and reliability of the local market, in which case could consider overseas investment in more mature stock exchanges
7. Tax

Question 9

Property

Discuss characteristics (9)

Answer 9

1. Spread (volatility)
   
   • highly volatile market value, many property markets suffer from some form of cycle
2. Yield (return)
   
   • normally associated with relatively high return
   • income in form of rent; low running yield, should increase in real terms
3. Security
   
   • normally seen as secure, though income stream may suffer occassional interruptions
4. Term
   
   • could be held in perpituity; very long term investment (like equity)
   • unlike equity, option of buying with intent to sell in short term no practical due to impact of dealing costs
5. Expenses
   
   • significant dealing expenses
   • also significant expenses incurred in administering/holding asset
6. Marketability
   
   • very unmarketable
7. Tax

Question 10

Cash

What do we mean by ‘cash instruments’? (1)

Discuss characteristics ( 7)

Answer 10

By cash, we normally mean

• money held on overnight accounts earning spot rates of interest

Investment characteristics of cash

1. Spread (volatility)
   
   • least variable value, especially in the short term
2. Yield (return)
   
   • relatively low return
3. Security
   
   • most secure asset class
4. Term
   
   • usually very short term
   • in fact, because of relatively low term, discounted mean is around zero
5. Expenses
   
   • very low dealing costs
6. Marketability
   
   • very liquid
7. Tax

Question 11

What is perfect liability matching? (1)

Why is asset liabiliity matching generally undesireable, and under what circumstances may it be desireable? (2)

Answer 11

Perfect asset liability matching is when

• assets are chosen whose proceeds are identical to outgo of money being paid out on liabilities, as they occur => would be no investment risk

Desireability/undesireability of asset liability matching

• perfect matching usually undesireable as it removes chance of investment profit
• may be desireable if company has very low free assets such that, without matching, probability of ruin would be unacceptably high

There is a distinction between

• cashflow mismatching
  
  • risk over time asset proceeds income less than outgo needed to meet liabilities due to such things as
    
    • having to buy assets in future at lower than expected yields
    • having to sell assets at depressed market values.
  • result of assets liability mismatch by nature, term or currency and its effect unfolds over time as actual cashflows take place (requires cashflow projection to assess mismatch.
• short term asset shocks risk
  
  • relates to whether company would continue to be able to meet its supervisory reserving requirements if market investment conditions were to change suddenly.
  • e.g. change in fixed interest yields or a fall in capital values of equity and property.
  • To identify this risk: analyse statutory solvency position under different assumptions of current investment conditions.
  • This is known as resilience testing.
  • To cover these risks the company may have to hold additional: reserves or solvency capital

Question 12

What is the difference between cashflow mistmatching, and risk from short term shocks in investment condidtions? (8)

Answer 12

There is a distinction between cashflow mismatching and risk from short term asset shocks

• cashflow mismatching
  
  • risk over time asset proceeds income less than outgo needed to meet liabilities due to such things as
    
    • having to buy assets in future at lower than expected yields
    • having to sell assets at depressed market values.
  • result of assets liability mismatch by nature, term or currency and its effect unfolds over time as actual cashflows take place (requires cashflow projection to assess mismatch.
• short term asset shocks risk
  
  • relates to whether company would continue to be able to meet its supervisory reserving requirements if market investment conditions were to change suddenly.
  • e.g. change in fixed interest yields or a fall in capital values of equity and property.
  • identify risk, analyse statutory solvency position under different assumptions of current investment conditions.
  • This is known as resilience testing.

Question 13

What are the cornerstone considerations which feed into the asset-liability matching process? (10)

Answer 13

Key cornerstones

• consider liabilities
  
  • currency, uncertainty, nature, term
  • whether we can achive perfect matching with liabilities
  • the level of mismatching we can sustain and its implications
• consider the effect of nature of liabilities on the types of investments held
  
  • for different types of liabilties, how must insurer best invest
  • liabilties might be
    
    • guaranteed in monetary terms
    • in terms of an index
    • discretionary
    • investment linked
• Consider impact of free assets

Question 14

What are the constituent parts of the liability outgo of a life company? (3)

Comment each constituent

Ben Pmts (10)

Exp (2)

Prem (2)

Answer 14

Insurer’s liabilities can be split into the following constinuent parts

• benefit payments, expenses, premium income

benefit payments

• guaranted in monetary terms
  
  • benefits where amount payable specified in contract in money terms.
  • thus includes guaranteed benefit payments under all forms of without profits contracts and the accrued contractual benefits under with profits contracts
• guaranteed in terms of an index of prices or similar
  
  • benefits whose amount is directly linked to such an index
• discretionary
  
  • consist of future bonus payments under with profits contracts and surrender values where these are not guaranteed.
  • level of discretion will depend upon bonus distribution method used.
• investment linked
  
  • consists of benefits under unit linked and index linked contracts, the amounts of which are determined directly by the value of investments underlying the contracts.

expense outgo

• expense pmts tend to increase at rate not strictly comparable change rate in price or earnings index,
• but for investment purposes, adequate to treat is as being so, hence included in benefit payments guaranteed in terms of index of prices or similar.

premium income

• usually fixed in monetary terms and hence can be thought of as negative benefit payments guaranteed in money terms.
• choice of premium to pay each year does not invalidate this.

Question 15

In an investment context, what do we normally mean by ‘term’ of an asset/liability? (4)

Answer 15

In an investment context, term normally refers to

• concept of discounted mean term (DMT, duration) rather than actual nominal term
• DMT defined as
  
  • weighted sum of the terms of payments
  • where the weight attributed to each term is the present value of the payment at that term. useful in considering an appropriate investment strategy.
  • matching liability DMT with suitable assets results in assets that move in value with the liability in the event of interest rate movements/flactuations

Question 16

In an investment context, what impact does currency/investing oversease play? (5)

Answer 16

Currency also plays a big role in investment strategy​​

• liabilities denominated in certain currency should be matched by assets in same currency, to reduce currency risk
• may also invest overseas
  
  • if liabilities are denominated in that overseas currency
  • for diversification
  • greater returns
  • gain access to different asset classes/types otherwise unavailable

Question 17

Liability nature effects on investment strategy: guaranteed in monetary terms

Discuss how an insurer will invest its assets for liabilities guaranteed in money terms (5)

Answer 17

• Insurer will invest to
  
  • ensure it can meet guarantees
  • this means investing in assets that produce flow of asset proceeds to match liability outgo, taking account of
    
    • term of liability outgo and
    • probability of payments being made
  • applicable to w/o-profits contracts + guaranteed component of w profits

Question 18

Liability nature effects on investment strategy: guaranteed in monetary terms

What type of assets would be best? (4)

Answer 18

Fixed interest assets would be best match

• though exact matching generally won’t be possible, as usually impossible to find assets whose proceeds exaclty match expected liability outgo
• particularly as terms of available fixed interest securities are often much shorter than corresponding liabilities
• a best match is all that can be hoped for

Question 19

Liability nature effects on investment strategy: guaranteed in monetary terms

Comment on the use of immunisation (8)

Answer 19

Immunisation may be useful to match liabilities guaranteed in monetary terms, as insurer would be protected against assets not covering liabilities in event of sudden interest rate moves; but subject to theoretical and practical problems:

• immunises against profits and losses
• difficult to immunise against real liabilities
• the theory only works/helps for small interest rate changes but in practice it is quite robust to large interest rate changes
• theory assumes a flat yield curve
• need to rebalance portfolio to immunised position constantly
• assets of required term may not exist
• assets proceeds timing unknown, and liabilities can only be estimated

Question 20

Liability nature effects on investment strategy: guaranteed in terms of index

Discuss how an insurer will invest its assets for liabilities guaranteed in terms of a prices index (5)

Answer 20

• Suitable match would be index-linked securities, where available…
• …ideally chosen to match expected term of liability outgo
• In their absense, invest in assets expected to provide ‘real’ return, eg
  
  • equities
  • properties

Question 21

Liability nature effects on investment strategy: discretionary benefits

Discuss how an insurer will invest its assets for discretionary benefits (6)

Answer 21

Main aim when investing for discretionary benefits is to maximise discretionary benefits, so invest in assets producing highest expected return

• Consider PH risk appetite
  
  • normally with profit PHs want high real return, but prefer
    
    • medium risk approach (guarantee outperform inflation),
    • to high risk approach (may give higher returns but could give very unsatisfactory returns).
• Recipients of discretionary benefits usually expect proceeds of contracts to maintain value in ‘real’ terms. So invest in assets expected to give ‘real return’
• Given these considerations, common approach is to invest in ‘blue-chip’ equities and properties

Question 22

Liability nature effects on investment strategy: discretionary benefits

How might the balance between discretionary (non-guaranteed) and guaranteed benefits impact investment strategy? (5)

Answer 22

Balance between discretionary/guaranteed benefits may also impact investment.

This depends on:
* the bonus philosophy of company
* a company which gives low guaranteed benefits/more terminal dividend may invest more in equities, only worrying about matching only closer to policy maturity
* level of free assets
* risk appetite of company
* published investment strategy
* PRE influenced by this, so insurer shouldn’t deviate too much from this
* insurer’s view of relative performance of various asset classes

Question 23

Liability nature effects on investment strategy: investment linked liabilities

Discuss how an insurer will invest its assets for investment linked liabilities (3)

Answer 23

• such benefits are guaranteed in the sense that their value can be determined at any time in accordance with definite formula, based on the value of a specified fund of assets or index.
• most common eg of liability: Unit-linked product
• insurer can avoid investment matching problems by investing in same assets as used to determine benefits. Often a regulatory requirement but if not, it is normal practice to do so, and one would need strong reason to support not doing so such as
  
  • insurer thought it could profit from such deliberate mismatch (units defined in terms of asset A, insurer thinks asset B will perform better over next 6 months, so assets invested by company to meet unit liabilities are switched from A to B

Question 24

Outline the impact of free assets on investment strategy (4)

Answer 24

Generally speaking

• free assets can be used as a cushion to reduce the probability of becoming insolvent
• allow company to mismatch/depart from matching strategies to improve overall return on its assets and thereby benefit:
  
  • PHs - through higher bonuses, or lower premium/charging rates
  • shareholders (if any) through higher dividends

The purpose of free assets is to protect the company from adverse experience so at least some of the assets chosen must not be too risky.

Question 25

What impact does free assets have on investment strategy in the context of guaranteed liabilities/benefits? (4)

Answer 25

• We expect that assets with highest expected return also have highest variability
• If assets supporting guaranteed benefits were invested in assets with highest expected return, the probability that asset proceeds will become inadequate may be too high for comfort ie. risk of insolvency too great
• Use of free assets is most appropriate in regard to the assets backing guaranteed benefits
  
  • so greater free assets, greater the freedoom in choosing investments for guaranteed liabilities
  • ie the greater the variability of return which the company can accept on backing assets

Question 26

What impact does free assets have on investment strategy in the context of discretionary benefits? (4)

Answer 26

When it comes to discretionary benefits

1. could be argued free assets irrelevant since insurer will want to invest in securities offering the highest expected return
2. on other hand, although benefits discretionary, PHs will expect to receive them and may have expectations as to their level so insurer will want use some free assets to ensure probability of discretionary benefits falling below certain level stays acceptable
3. so free assets can support riskier asset profile than company would otherwise be prepared to implement

Question 27

What impact does free assets have on investment strategy in the context of investment linked benefits? (5)

Answer 27

When it comes to investment linked benefits

1. Reasonable use of free assets to mismatch these benefits, if by doing so the company can expect to achieve a higher return. If this is done any return achieved above or below that of the matched assets will not accrue to the unit linked policyholders but to the owners of the company.
2. Risk of sizeable loss too great, and thus not commonly done, even if the risk can be absorbed by free assets.
3. This increase the amount of capital needed to write business (additional reserves to cover mismatching risk needed), which could increase the cost of the product.
4. Might not be permitted by regulation.

Question 28

Describe the approach an insurer could take to developing a ‘minimum risk’ investment strategy.

(Categorise, match, 4)

(Free assets, 3)

(Cash, 1)

(Regulation, 1)

Answer 28

1. categorise liabilities: guaranteed in terms of monetary/index, investment linked, discretionary
   
   • match invesmtent linked liabilities exactly
     
     • invest in assets underlying benefit determination formula
   • match liabilities guaranteed in reference to index
     
     • if possible, if not possible choose nearest thing
   • match liabilities guaranteed in monetary terms
     
     • with government bonds & possibly some corporate bonds of suitable term
   • discretionary benefits
     
     • ideally invest in equity and property
     • normally weighted towards equity, because of difficulty associated with property (expensive to deal, to administer, comes in large chunks)
     • low to medium risk equity shares, typically major blue chip companies or index tracking
2. free assets
   
   • normally invested in equities and property
   • company can adopt slightly riskier stance than for discretionary benefits in equity selection and could invest overseas without necessarily having to hedge currency risk
   • common to have significant property investment in shape of company’s own premises
3. include sufficient cash
   
   • for company to operate on daily basis without need to realise any non cash assets
4. consider regulation
   
   • any regulatory constraints that may apply

Question 29

Outline the process for determining an optimal investment strategy using an asset-liability model (lots of points…easily 10 marks in an exam))

1. Model
2. Allocate free assets
3. Stochastics
4. Solvency cap req checks
5. Profit measure
6. Repeat
7. Identify

Answer 29

1. Using a model of business in force, a model investment portfolio can be built up based on company’s proposed/current investment strategy
2. Allocate adquate proportion free assets to support underlying reserves
   
   • “appropriate proportion”=>determined from asset liability investigations done; only take proportion as
     
     • capital providers may not want all their assets used to support PHs investment strategy (free assets may disappear to pay for any losses arising from mismatch, especially since additonal return earned will be for benefit of PHs)
     • may also be inadmissable under local statute as assets to cover reserves or any SCR.
3. Project forward the company’s future assets and liabilities
   
   • use expected future experience for assumptions
   • test variations on these best estimate assumptions
   • liabilities
     
     • current basis & project forward to year end on supervisory basis
     • could incorporate into the simulation exercise dynamic assumptions which take into account investment conditions.
   • assets
     
     • using assumptions for future investment return
     • use stochastic investment model to project future investment income & capital gains/losses + stochastic inflation rate models for future expenses
   • may also account for future new business growth plans, hence future new business strain
   • use stochastic investment model and simulation techniques extended to produce a statistical distribution of the amts available annually to cover the level of SCR required. This can be used to estimate the probability of future insolvency given a particular investment strategy.
4. Check excess of V(assets) over V(liabilities) is sufficient to comfortably cover the level of SCR required by the company. This depends on the regulatory requirements, nature of business and level of cover provided by other companies.
   
   • for entire proj period for chosen confidence level (eg 99% of sims)
5. Identify success measure useful to compare invest strategies eg profitabiliity
   
   • proprietary: some measure of distributed profit over future horizon
   • mutual: more difficult, as with profits PHs return matter most)
   • highest expected returns isn’t always most successful, as also depends on how liabilities move…consider overall profit emerging
6. Repeat steps assuming different investment strategies until target probability of insolvency achieved.

Simulations could also be used to determine the level of free assets that the company needs in order to support a particular investment strategy and keep P(insolvency) < an acceptably low figure.

7. Identify which of the possible strategies, having equal insolvency risk, produces highest profitability

Question 30

List 4 aspects of a life insurer’s financial position that could be investigated using asset-liability modelling (5)

Answer 30

4 aspects of an insurer’s financial position which can be investigated using model office

1. Level of riskiness of investment strategy that can be supported
2. Level of free assets required to support any business strategy
3. probability of insolvency
4. interdependence between above three aspects
5. effect on future shareholder earnings (for a proprietary company)
   
   • in particular, investment strat which maximises shareholder income whilst keeping insolvency risk sufficientely low bearing in mind available level of free assets

Answer 31

The following will make an investment strategy riskier (interpreting risk as “variability of return”):
For assets backing some given liabilities:
- reduce the amount of matching by nature,
- reduce the amount of matching by term, and
- reduce the amount of matching by currency

and looking at assets in isolation (ie assuming there are no associated liabilities):
- increase duration.

And in both cases:
- move from government to corporate bonds,
- move from AAA-rated corporate bonds down to something lower,
- for equity stock, move from an established company to a new company …
- … or from an established sector to a new sector.

A life company would not normally increase risk by reducing diversification as there is no extra return for taking on specific risk (whereas systematic risk is generally rewarded with higher expected returns).

A company would never increase risk unless it also leads to increased expected profitability.