Ch 33: Investment

Question 1

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

Answer 1

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

Question 2

Asset characteristics
3 Key factors
(1,6)
(1,1)
(1,3)

Answer 2

1. Return’ is the most important,
   
   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
2. Statutory constraints on insurer holding certain assets
   
   3. TECH SCAM
3. 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 3

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

Answer 3

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 4

Government fixed interest bonds

Discuss characteristics (10)

Answer 4

1. Spread (volatility):
   
   • return is fixed if 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 5

Government index linked bonds

Discuss characteristics (9)

Answer 5

1. Spread (volatility)
   
   • return is fixed if 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 6

Corporate fixed interest bonds

Discuss characteristics (9)

Answer 6

1. Spread (volatility)
   
   • fixed return, if held to maturity and no default
   • market value fluctuates 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 government 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 7

Equities

Discuss characteristics (13)

Answer 7

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
   
   • can be held in perpetuity
   • 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 developed markets, but there are unmarketable equities
   • 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 8

Property

Discuss characteristics (9)

Answer 8

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 9

Cash

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

Discuss characteristics ( 7)

Answer 9

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 10

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

Answer 10

Principles of investment

1. To minimise risk, insurer should select investments that are appropriate to nature, term and currency of liabilities
2. Subject to this Investments should be selected to maximise overall return on assets, including botn investment income and capital gains
3. Extent to which ‘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 11

Asset liability matching

What is perfect liability matching? (1)

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

Answer 11

Asset liability matching is when
* Proceeds from assets should match (timing and amt) the outflow from liab
* Reduce investment risk

Perfect asset liability matching
* Perfect matching undesireable as it removes chance of investment profit
* Perfect matching may come at high cost, hold large portfolio
* Assets may not be available to match perfectly
* Liability outgo is uncertain
* Desireable if company has very low free assets such that, without matching, probability of ruin would be unacceptably high

Question 12

NUCT of liabilities? (5)

Answer 12

• consider liabilities
  
  • Nature, Uncertainty, Currency , Term
  • whether we can achive perfect matching with liabilities
  • the level of mismatching we can sustain and its implications
• Consider impact of free assets

Question 13

Nature of liabilities

Benefits Payments (10)

Expenses (2)

Premiums (2)

Answer 13

Benefit payments
* Guaranted in monetary terms
* Amount specified and Guaranteed by contract in money terms.
* All w/o profits and Guar w/profits
* Guaranteed index-linked
* Benefits whose amount is directly linked to perf of 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/Unit linked
* consists of benefits under unit linked contracts, the amounts of which are determined directly by the value of investments underlying the contracts.

Expense outgo

• expense pmts tend to increase over time
• eg at inflation or change in price or earnings index,
• but for investment purposes, adequate to treat is as being so, hence included in benefit payments guaranteed index-linked

Premium income
* usually fixed in monetary terms and hence can be thought of as guaranteed in money terms.
* choice of premium to pay each year does not invalidate this.

Question 14

Term of Liabilities

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

Answer 14

In an investment context, term normally refers to

• 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.
  • Matching liability DMT with suitable assets results in assets that move in value with the liability
  • Immunisation in the event of interest rate movements

Question 15

Currency of liabilities

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

Answer 15

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 16

Mismatching vs Resilience

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

Answer 16

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 17

Effects of Nature of Liability on investment strategy: guaranteed in monetary terms

Discuss how an insurer will invest its assets for liabilities guaranteed in money terms (2)
Perfect matching possible? (3)
Immunisation (6)
Asset class for best match

Answer 17

• Insurer will invest to
  
  • Ensure it can meet guarantees
  • Match considering Term and Uncertainty of Liabilities
• Perfect match not possible:
  
  • impossible to find assets whose proceeds exactly match expected liability outgo
  • particularly as terms of available fixed interest securities are often much shorter than corresponding liabilities
  • ST asset proceeds + prems will then need to be reinvested @ unknown rates (risk)
• Immunisation:
  
  • Asset and Liab values move together for small changes in interest rate
  • Loss of mismatching profits
  • Only helpful for small interest changes
  • Rebalance portfolio to immunised position constantly
  • Assets of required term may not exist
  • Assets proceeds timing unknown, and liabilities can only be estimated
• Fixed interest Securities provide best match

Question 18

Effects of Nature of Liability 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 18

• Best match would be index-linked securities
• …ideally chosen to match expected term of liability outgo
• Or invest in assets expected to provide ‘real’ return, eg
  
  • equities
  • properties

Question 19

Effects of Nature of Liability on investment strategy: discretionary benefits

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

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

Answer 19

• Aim to maximise discretionary benefits, so invest in assets producing highest expected return
• Consider PH risk appetite, with profit PHs want high real return
  
  • medium risk approach (guarantee outperform inflation),
  • to high risk approach (rather take out UL policy instead).
• Recipients of discretionary benefits usually expect proceeds of contracts to maintain value in ‘real’ terms.
  
  • Best match is to invest in ‘blue-chip’ equities as lower risk (property)

Balance between discretionary/guaranteed benefits may also impact investment
* Bonus philosophy
* low guaranteed benefits + high terminal bonuses
* => more equities and match closer to policy maturity
* Level of free assets
* HIgher level more risky investment strategy
* Risk appetite of company
* Published investment strategy
* Form PRE, so insurer shouldn’t deviate too much from this
* insurer’s view of relative performance of various asset classes

acronym

Question 20

Effects of Nature of Liability on investment strategy: investment linked liabilities

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

Answer 20

• such benefits are guaranteed in the sense that their value can be determined at any time in accordance with definite formula, based on value of specified fund of assets (or investment index)
• insurer can avoid investment matching problems by investing in same assets as used to determine benefits
• often regulatory requirement to invest these same assets, and would need strong reason to support not doing so
  
  • 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 21

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

Answer 21

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

Question 22

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

Answer 22

• 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 23

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

Answer 23

When it comes to discretionary benefits

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

Question 24

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

Answer 24

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. this 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 25

Describe the approach an insurer could take to developing an investment strategy

(Categorise, match, 4)

(Free assets, 3)

(Cash, 1)

(Regulation, 1)

Answer 25

1. Categorise liabilities by nature:
   
   • 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. Invest 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 26

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 26

1. Using 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 admissibility issues
3. Perform projections of company’s future assets and liabilities
   
   • use expected future experience for assumptions
   • test variations on these best estimate assumptions
   • for liabilities use
     
     • current basis & project forward to year end on supervisory basis
     • need assumptions to be dynamic & linked to proj basis assumptions
   • project assets forward
     
     • using assumptions for future investment return
     • incorporate 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
   • stochastic proj results will give statistical distribution of amounts available to meet solvency cap requirement, hence calc probability of future insolvency
4. Check excess of assets over liabilities exceeds any minimum capital requirement (or multiple thereof)
   
   • for entire proj period for chosen confidence level (eg 99% of sims)
   • need to identify confidence level, depending on regulatory reqs, nature of business, and level of cover over solvency margin provided by competitors
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
7. Identify which of the possible strategies, having equal insolvency risk, produces highest profitability

Question 27

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

Answer 27

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