Ch 33: Investment Flashcards
State the 3 main principles of investment for a life insurance company (5) and how can these investment principles be summarised (2)?
Principles of investment
- To minimise risk, insurer should select investments that are appropriate to nature, term and currency of liabilities
- Investments should be selected to maximise overall return on assets, where overall return includes both investment income and capital gains
- The extent to which the ‘appropriate’ investments referred to above may be departed from to maximise overall return will depend, amongst other things, on
- extent of company’s free assets
- 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
List the 4 main asset classes in descending order of (likely) expected return (4)
Main assset classes in descending order of (likely) expected return
- equities and property
- corporate bonds
- government bonds
- cash and money market instruments
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)
We can consider asset types according to the following key “SYSTEM T” characteristics
- Spread (volatility)
- Yield (return)
- Security
- Term
- Expenses
- Marketability
- Tax
Of the above characteristics, ‘yield/return’ is the most important, in particular
- how much expected return will be
- whether return is real vs nominal
- split of return between income and capital gain
- whether running yield sufficient for investors’ needs
- variance of return
- tax implications for return
In addition to the highly important ‘investment return’ asset class characteristics, what 2 other factors are of key importance? (2)
- Statutory constraints on insurer holding certain assets
- Tax implications
- tax reduces returns
- tax regime may favour investment in particular assets
- tax regime may favour income over capital gain (or vice versa)
Government fixed interest bonds
Discuss characteristics (10)
- 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
- 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
- Security:
- very secure, most secure asset class other than cash
- Term:
- depends on market, typical 15 to 20 years
- Expenses:
- low dealing costs
- Marketability:
- most marketable and common asset type
- Tax:
Government index linked bonds
Discuss characteristics (9)
- 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
- Yield (return)
- payments defined in terms of index eg price inflation => impacts returns
- Security
- very secure, as with fixed interest gov bonds
- Term
- less variety than gov fixed interest bonds + smaller amounts issues
- Expenses
- probably low dealing costs, but more expensive than gov fixed interest, as less variety traded
- Marketability
- lower marketability than gov bonds, because of less variety/smaller amts
- Tax
Corporate fixed interest bonds
Discuss characteristics (9)
- Spread (volatility)
- non volatile return, if held to maturity
- market value flactuates with markets, but less important if held to redemption
- Yield (return)
- higher return than government fixed interest bonds of same term
- running yield similar to prevailing market interest rates for term concerned
- Security
- less secure than governemt bonds
- can be a problem if issuing company not AAA rated
- Term
- terms similar to government bonds
- Expenses
- higher dealing
- Marketability
- lower marketability
- Tax
Equities
Discuss characteristics (13)
- 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
- 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
- Security
- underlying company itself might go bakrupt/perform badly
- 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
- Expenses
- usually low dealing costs; depends on how developed market is
- 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
- Tax
Property
Discuss characteristics (9)
- Spread (volatility)
- highly volatile market value, many property markets suffer from some form of cycle
- Yield (return)
- normally associated with relatively high return
- income in form of rent; low running yield, should increase in real terms
- Security
- normally seen as secure, though income stream may suffer occassional interruptions
- 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
- Expenses
- significant dealing expenses
- also significant expenses incurred in administering/holding asset
- Marketability
- very unmarketable
- Tax
Cash
What do we mean by ‘cash instruments’? (1)
Discuss characteristics ( 7)
By cash, we normally mean
- money held on overnight accounts earning spot rates of interest
Investment characteristics of cash
- Spread (volatility)
- least variable value, especially in the short term
- Yield (return)
- relatively low return
- Security
- most secure asset class
- Term
- usually very short term
- in fact, because of relatively low term, discounted mean is around zero
- Expenses
- very low dealing costs
- Marketability
- very liquid
- Tax
What is perfect liability matching? (1)
Why is asset liabiliity matching generally undesireable, and under what circumstances may it be desireable? (2)
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.
- risk over time asset proceeds income less than outgo needed to meet liabilities due to such things as
- 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
What is the difference between cashflow mistmatching, and risk from short term shocks in investment condidtions? (8)
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.
- risk over time asset proceeds income less than outgo needed to meet liabilities due to such things as
-
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.
What are the cornerstone considerations which feed into the asset-liability matching process? (10)
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
What are the constituent parts of the liability outgo of a life company? (3)
Comment each constituent
Ben Pmts (10)
Exp (2)
Prem (2)
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.
In an investment context, what do we normally mean by ‘term’ of an asset/liability? (4)
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