Chapter 19: Investment principles and ALM Flashcards

1
Q

2 type of returns that shareholders of an insurer is interested in

A
  • an insurance (or underwriting) result, and

- an investment result

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2
Q

Primary objectives of investment

A

To maximise return subject to meeting contractual obligations:
- meeting claims and expenses as they fall due
- maintaining statutory solvency and any internal company solvency constraints.
The risk of not earning a return is within the scope of the insurer’s risk tolerance.

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3
Q

The risk appetite of the insurer will depend on (4)

A

Its
- liabilities

  • assets currently held
  • external influences
  • insurer-specific constraints
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4
Q

7 Liability characteristics that need to be considered

A
  • nature - real or fixed liabilities?
  • currency
  • term
  • level of uncertainty (timing and amount)
    of existing liabilities
  • estimated future liabilities arising from the portfolio of business planned
  • location of liabilities
  • whether the liabilities are discounted.
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5
Q

“The nature of existing liabilities”

A

Are they fixed or “real” in monetary terms.

The majority of general insurance liabilities will be real in nature.

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6
Q

“Currency of existing liabilities”

A

Many domestic, personal and commercial insurers may have portfolios predominantly denominated in their local currency.
However, international insurers and reinsurers have portfolios that contain a range of currencies.

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7
Q

“Term of existing liabilities”

A

Most general insurers’ portfolios are likely to contain a significant proportion of short-term liabilities (1-3 years), with a smaller proportion of medium-term (4-10 years) and long-term liabilities (10+ years)

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8
Q

6 Considerations with respect to the assets

A
  • size of the assets, in relation to the current liabilities
  • expected long-term return from various asset classes
  • expected volatility within the various asset classes
  • existing asset portfolio
  • non-investible funds
  • economic outlook
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9
Q

Free reserves

A

The excess of the value of an insurer’s assets over its technical reserves and current liabilities.

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10
Q

Monies not available for investment include (3)

A

monies held by:

  • agents (eg brokers holding premiums for two months before passing them on)
  • policyholders (eg premium payments by instalment, or end-of-year adjustment premiums due to exposure adjustments or experience rating)
  • reinsurers (ie delays in making recoveries)
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11
Q

7 External influences on investments

A
  • tax treatment of different investment and the tax position of the general insurer
  • statutory, legal, ethical or voluntary restrictions on how the insurer may invest
  • statutory valuation requirements
  • solvency requirements
  • rating agency constraints on capital required to maintain the insurer’s desired rating, and therefore a better image and better terms for raising future capital
  • competition - strategy followed by other funds
  • regulatory constraints eg. Lloyds, PRA or FCA
    -investment / economic conditions
    - claims inflation
     the risk of catastrophes
     seasonal effects
     any non-investible funds
    shareholders’ expectations
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12
Q

2 Insurer-specific investment considerations

A
  • Risk appetite

- Company-specific investment objectives

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13
Q

3 Possible insurer situations wrt cashflow

A
  • insurer expects that premiums and investment income will continue to exceed claim payments for the indefinite future
  • insurer is in run-off and expects to have to rely on the maturity and realisation of assets
  • insurer has suffered a major insurance event and needs to obtain short-term liquidity in order to settle claims
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14
Q

2 fundamental choices when modelling future liability outgo

A
  • whether to include premium income and outgo relating to business that will be written after the accounting date, which will depend on whether the exercise is to assess ongoing profitability, solvency an investment policy
  • only the liability outgo relating to the existing liabilities (for business already written), which will depend on whether the exercise is to determine assets suitable for matching to existing liabilities.

The aim is to project, on a BEST ESTIMATE basis, the overall liability outgo in each future time period.

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15
Q

Overall liability outgo can be calculated as (5)

A
liability outgo = 
total gross claim payments
- reinsurance and other recoveries
\+ expenses
- outstanding premiums received
\+ tax and dividend payments
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16
Q

Claim payment projection must include (4)

A
  • all future payments in respect of unsettled reported claims
  • IBNR and reopened claims
  • claims that will emerge from unexpired risks
  • claims that will emerge from new business
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17
Q

4 important considerations in an investment income projection

A
  • income from investment
  • any capital proceeds, eg the redemption payments on any maturing bonds, during the period of consideration
  • the expenses of investment
  • the future volatility of capital values and investment income
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18
Q

possible solvency requirements might be related to (4)

These requirements can also be self imposed by an insurer

A
  • the length of tail
  • the likelihood of catastrophes and accumulations
  • the spread of risk groups within the portfolio, ie how well diversified the insurer is by the classes written
  • the insurer’s experience in writing the class and therefore how predictable the liability outgo is.
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19
Q

The purposes of a new business projection might be to assess (3)

A

The purposes of a new business projection might be to assess

  • the future solvency of the office under different volumes of new business
  • the future solvency under different scenarios for asset distributions, or
  • the likely levels of profitability
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20
Q

6 risks relating to an insurer’s investment strategy

A
  • liquidity
  • currency
  • market
  • credit
  • Economic
  • group

Others:
Operational
Contagion
Relative performance risk

21
Q

Liquidity risk

A

The risk of not having sufficient cash to meet the liabilities as they fall due.

22
Q

currency risk

A

the risk that changes in the values of the assets, or the liabilities of the company adversely impact the available capital or investment funds.

23
Q

Market risk

A

The risk relating to changes in the value of the portfolio due to movements in the market value of the assets held.

24
Q

Economic risk

A

The risk of investing in certain asset classes at certain stages in the economic cycle when the assets are overpriced.

25
Q

Credit risk

A

The risk that a counterparty to an agreement will be unable or unwilling to fulfil its obligations.

26
Q

Group risk

A

The risk, for example, that an insurance subsidiary might be required to change investment strategy following a change in the parent’s requirements.

27
Q

Asset liability modelling (ALM)

A

Any model that covers both the assets and liabilities of an entity within one structure.
This means that ALM is generally an extension of other models.

28
Q

The basic concept behind ALM (6). i.e. how does an ALM work?

A

What is ALM?
ALM is a term used to describe any model that covers both the asset and liabilities of an entity within one structure. This means that an ALM is generally an extension of other models mentioned within these notes, as the basic building blocks of an ALM will be other stochastic or deterministic sub-models, that is, an asset model and a liability model, and the links between the two.

  • project liability outgo in each future time period for a chosen timeframe
  • project asset proceeds in each future period
  • compare the two for each future period
  • run the comparisons again using different assumptions
  • decide whether the asset proceeds are appropriate for the liability outgo
  • if not, investigate alternative asset distributions
29
Q

Describe the characteristics of the liabilities of employer’s liability insurance

A

Liabilities relating to injury or disease will be LONG-TAILED due to

  • reporting delays
  • settlement delays
  • possible benefits in the form of regular payments.

Legal environment will have a significant effect on settlement delays.

Claims that relate to property damage will be much shorter-tailed due to shorter reporting delays and settlement delays.
Claims relating to property damage are relatively small compared to those for bodily injury and disease and death.

All claims will be inflation-linked:

  • MEDICAL inflation for injury or disease
  • WAGE inflation for compensation for loss of income
  • COURT AWARD inflation, which may be higher than medical or wage inflation in some legal jurisdictions where there is bias in favour of claimants.
  • LEGAL costs and claims handling costs
  • PROPERTY damage will be inflation linked.

If the employer has operations in a number of countries, claims will probably need to be settled in the country where the liability arose, hence claims could be denominated in a variety of currencies.

30
Q

Why might reporting delays exist with liability insurance?

A

Potential claims could remain undetected for many years.

The long tail is exacerbated if the cover was written on a losses-occurring basis.

31
Q

Why might settlement delays exist with liability insurance?

A

These could extend over a number of years caused by the need to establish the extent of the liability.
Litigation for large claims will usually further extend the tail of claims by several months or years.

32
Q

5 Suitable assets for a liability insurer

A

INDEX-LINKED BONDS
To the extent that these are available for appropriate maturity terms; these bonds will provide returns linked to an inflation index. However they will unlikely match medical and wage inflation.

EQUITIES
These are expected to provide a return over long terms that exceeds the increase in consumer prices, and hence could be a good match for long-tailed liability returns.

FIXED-INTEREST BONDS
These should be available at various terms, and returns do allow for inflation expectations at the time of purchase, however as returns are fixed in monetary terms they do not provide for protection against unexpected inflation.
Hence they are not suitable for long-tailed inflation-linked claims, but could be suitable for short and even medium-term inflation linked claims, as even if inflation differs from expected, the timescale is such that it should not lead to a material loss of real value.

CASH
Returns depend on monetary policy, however cash returns should be loosely linked to consumer price inflation, however there will likely be periods of negative real returns. Cash is highly liquid, however this may not be a significant factor for an insurer with mostly long-tailed liabilities.

PROPERTY
While property is expected to provide real returns in the long term, direct property would not be suitable for a small insurer.
Indirect property might be suitable, provided it is reasonably liquid and sufficiently diversified and invested in good quality commercial properties.
Dealing and management costs are relatively high.

33
Q

9 Factors that influence the extent to which a company might mismatch its assets

A
  • SIZE OF THE COMPANY (and the risk of insolvency)
  • LEVEL OF FREE ASSETS
  • NEED FOR DIVERSIFICATION to reduce investment market risk may lead to mismatching
  • AVAILABILITY OF SUITABLE ASSETS in the emerging market may force some mismatching.
  • EXTENT OF REINSURANCE may increase investment freedom.
  • ATTITUDE TO RISK
  • ACCESS TO PARENT company resources
  • OUTLOOK FOR RETURNS for various asset classes
  • REGULATORY REQUIREMENTS
  • The extent on which the insurer can relay in premium income to meet short-term expenses and claims may allow it to mismatch.
34
Q

Reasons why it is important to adjust premium rates to keep up with new technology include (4)

A

Premiums need to cover all costs incurred by the insurer, including claims costs.

Changes in technology have the potential to increase or decrease these costs and hence the premium needs to change accordingly.

If premiums are not increased when claims costs increase then insurers will make losses.

If premiums are not decreased when claims costs reduce, the insurer may be overpriced compared to competitors and hence lose business to competitors.

  • the business that will be lost will be the better risks as premiums are too high relative to the risk they present to the insurer.
  • The business lost could also be the larger policies, which may result in a problem of recovering fixed expenses if larger policies contributed more to fixed expenses.
  • Irrespective of the size of policies lost, lower business volumes will reduce the insurer’s ability to recover fixed costs.
35
Q

Six factors that could determine the importance of regularly updating premium rates to take account of new technology

A
  • Frequency of significant improvements in technology. The more frequent the improvement, the more frequently updates are required to remain up to date.
  • Customer loyalty.
  • Cost of the premium update. Cost-benefit analysis.
  • Percentage of policyholders to whom the new technology will apply
  • Level of competition in the market.
  • Strategy of the insurer. (E.g. leading the market)
36
Q

Characteristics of creditor insurance liaiblities

A

Mostly fixed:

  • payments on personal loan policies will be the monthly repayment specified in the loan agreement; such loans are usually issued at a fixed interest rate.
  • payments on credit card policies are usually the minimum monthly payments on the balance prior to claiming.
  • payments on mortgage policies are normally a set amount selected by the insured at policy inception, and linked to the monthly repayment.

Occasionally the benefit may be variable and linked to interest rates. To the extent that interest rates reflect inflationary expectations, these benefit payments may be regarded as real in nature.

Term of liabilities:
Usually a maximum number of benefit payments, and this will determine the maximum term of the liabilities.

Currency of liabilities:
Benefits paid and premiums received will usually be in the currency of the country that the insurer operates in.

Uncertainty of the liabilities:

  • Economic circumstances, Recessions will increase claims
  • Recessions may also lead to higher claims
  • Interest rates: if the benefit payment is linked to this, higher interest rates increase benefit amounts
  • Access to healthcare and medical advances could reduce disability recovery time and hence benefit payments
  • Moral hazard.
37
Q

9 key considerations in reviewing the investment strategy

A
  • The nature, term, currency, location and uncertainty of the liabilities.
  • The level of free assets
  • Company risk appetite and any ethical or voluntary restrictions.
  • Tax, Legal and regulatory requirements
  • Extent to which new business may be relied upon for cashflows.
  • Diversification
  • Existing assets
  • Level of non-investible funds influences the level of liquidity required from investible assets.
  • Economic outlook may influence some of the asset decisions.
  • Rating agency constraints on free assets required to maintain credit ratings.
  • Competitor strategies.
38
Q

Advantages of stochastic ALM

A

Better for considering a BIGGER SET of possible scenarios

The scenarios are chosen randomly and therefore not subject to the modeller’s potential biases and limited perspective

A stochastic model’s outputs incorporate probabilities (thus the likelihood of unfavourable outcomes associated with particular investment strategies), while the output from a deterministic model does not.

Risk-based solvency regimes like SAM and Solvency II require a better understanding of risks faced by the company which are better modelled by a stochastic ALM.

Both stochastic and deterministic ALMs can allow for suitable interaction between assets and liabilities. (so this is not a difference)

39
Q

Disadvantages of stochastic ALM

A

Stochastic models may have higher risk (due to greater complexity) and introduce spurious accuracy in the modelling.

Practical difficulties are greater for stochastic models:

  • Stochastic models are MORE DIFFICULT TO BUILD, calibrate and run.
  • They REQUIRE MORE DATA than deterministic models.
  • More COSTLY to obtain (build or purchase) and to maintain.
  • The output may be more DIFFICULT TO INTERPRET.
  • More TIME CONSUMING to run.
40
Q

Explain the purpose of an ESG within an ALM exercise.

A

An ESG typically takes the form of a specialised asset model that stochastically models various asset classes.

The output from an ESG includes the performance of each economic variable (e.g. inflation, asset class returns, GDP, etc.) at each future projection point for several simulations.

The table of simulation outputs will be used as an input for the ALM.

41
Q

List the statutory restrictions on a General Insurer’s investment strategy

A
  1. restriction on the amount of certain types of assets that can be considered when assessing solvency
  2. Custodianship of assets
  3. Prevention from holding certain assets
  4. Prescription to hold certain assets
  5. Requirement to hold mismatching reserves
42
Q

List reasons why in practice the assets held by a general insurer may not be a perfect match for the liabilities

A

The company may choose not to match the liabilities (eg if it has plenty of free reserves).
If the company is making underwriting losses, an unmatched position may be taken to try to make investment profits to offset these losses.
The company may be forced to invest in much shorter, liquid assets with a more stable market value, in order to protect its statutory solvency position.
The timing of the liabilities will be uncertain and therefore difficult to match.
It may not be possible to match, eg if claims inflation is different from the inflation protection available from real assets.
There may be regulatory limits on the amount of assets that can be invested in certain asset classes.
Matching assets may not be available.

43
Q

Comment briefly on the suitability of government bonds and direct property as investments for the following:

(i) meeting claims from household contents insurance
(ii) meeting claims from employers’ liability insurance
(iii) free reserves (ie shareholders’ funds)

A

(i) Household contents
Short-term bonds are suitable for household contents. Longer-term bonds are unsuitable as the liabilities are short tailed.
Direct property would be unsuitable for household business because of lack of marketability and large unit size. Also investments would be too long-term. (ii)
Employers’ liability
Bonds would not really be appropriate for employers’ liability as real assets would be a better match.
Property is also probably unsuitable. Although the nature and term may be about right (or less wrong than other assets), the lack of marketability could be a problem.
The large unit size would also make it difficult to hold a sufficiently diversified portfolio. (iii)
Free reserves
Bonds are not normally appropriate for free reserves. We prefer assets that have a higher expected return and offer better protection against inflation.
Direct property could be acceptable for a portion of the free reserves. The insurer’s own office may form part of the assets.

44
Q

(i) Outline the situations in which a supervisory authority is likely to impose restrictions on a general insurer’s investment holdings and their valuation.
(ii) List examples of the controls the supervisory authority may impose

A

(i) Situations where restrictions may be imposed
The regulator may deem it appropriate to impose restrictions:
on the market in general
on insurers selling particular product lines at certain stages of development
where an insurer is in difficulty, having breached or being in danger of breaching regulations.
(ii) Examples of controls
restrictions on the amount of certain types of assets that can be taken into account when assessing solvency
custodianship of assets
prevention from holding certain assets a prescription to hold certain assets
a requirement to hold mismatching reserves limitations on the ability to mismatch

45
Q

A general insurer writes private motor business only. Discuss the suitability of investing the company’s assets in government securities denominated by the insurer’s own government

A

Positive factors:

  • limited risk of default (but depends upon the government)
  • highly marketable, and therefore useful if there is fluctuation in claim outgo
  • short-dated securities have relatively stable market values
  • right currency for matching local liabilities
  • short-dated securities have the right term for matching property damage claims
  • fixed-interest stocks are appropriate for property damage claims (to the extent that short-term inflation is largely predictable)
  • index-linked stocks provide inflation protection for the longer-tail, liability classes low dealing costs and may tax efficiency.

Negative factors:

  • they will not provide the best expected return
  • funds backing the free reserves may be invested in more aggressive assets
  • long-dated stocks can have volatile market values (not so good if statutory asset valuation is based upon market values)
  • long-dated, fixed-interest stocks provide no inflation protection and do not match short-term liabilities
  • the inflation within index-linked stocks may not provide the right type of inflation protection.
  • the extent to which government stocks are used (and the extent of attempted matching) will depend on the level of free reserves relative to any required solvency margin.
46
Q

List the different types of non-investible funds that the insurer may hold and explain how they affect the financial management of the company.

A

Non-investible funds are monies held: 
    
by reinsurers (ie who are due to pay a reinsurance claim) … … this figure may be net of any bad debt provision by agents and brokers who owe premiums to the company by policyholders who are paying premiums by instalments
by policyholders who pay end of year adjustments to premiums, because of exposure adjustments or experience rating
by policyholders who are slow to pay premiums. Effect on financial management
Non-investible funds will not earn any investment income. Therefore, if the insurer has a large proportion of non-investible funds, profits will be reduced or higher premiums need to be charged.
The company may try and counter this effect by investing a higher proportion of the remaining funds in assets with a higher expected return.
[1⁄2 each, maximum 3] [1] [1⁄2]
As non-investible funds are short-term assets then a smaller proportion of the remaining portfolio needs to be invested short.
However, if the company is concerned about the default risk of the non-investible funds then it may look for greater security from the investible assets.
Alternatively it may set aside provisions for bad debts.
There may be a regulatory limit that restricts the level of non-investible funds that can be included when demonstrating solvency. The company should ensure that solvency is not jeopardised.

47
Q

What are the external influences that affects an insurer’s risk appetite?

A

External influences on risk appetite
tax treatment of various assets and the tax position of the general insurer statutory, legal, ethical or voluntary restrictions on how the insurer may invest statutory valuation requirements
[1⁄2] [1⁄2] [1⁄2]
solvency requirements and the size of the insurer’s free reserves relative to these [1⁄2] capital required to maintain the insurer’s desired credit rating competition, ie the investment strategy followed by other funds regulatory constraints, eg imposed by Lloyd’s or the PRA

48
Q

S2014, Q. 9
Changes are made to the law of a particular country that make it much more likely that claims will now be settled in the form of annual payments rather than lump sums. (iii) Describe modifications that may be required to the reinsurer’s investment policy following this change.

A

Liabilities are now likely to be much longer term than under lump sum..
…therefore likely to be significant mismatch between assets and liabilities.
Ideally should have assets that are linked to inflation that match outgo..
..but unlikely to be able to match wage inflation so may need RPI/CPI as
proxy.
Uncertainty in future life expectancies and therefore term very difficult to
match..
..perhaps longevity based derivatives but could be expensive and risky.
Require annual income to meet the annuity component of payment..
..although could be met out of future premium income if business is ongoing.
Depends on the proportion of reserves/liabilities that are likely to settle in this
way..
..if only a small proportion of portfolio no significant action may be needed
or if free assets are large so lots of flexibility may not be as affected
..particularly if the costs of changing portfolio are high/returns are poor
Availability of assets could be a problem as long duration investments may not
exist..
..or competition from other investors such as pension funds may make them
costly.