Chapter 21: Investment principles and ALM

Question 1

2 Components of return to shareholders of an insurer

Answer 1

• an insurance (or underwriting) result, and

- an investment result

Question 2

Primary objectives of investment

Answer 2

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.

Question 3

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

Answer 3

Its

• liabilities
• assets
• external influences
• insurer-specific constraints

Question 4

7 Liability characteristics that need to be considered

Answer 4

• nature
• 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.

Question 5

“The nature of existing liabilities”

Answer 5

Are they fixed or “real” in monetary terms.

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

Question 6

“Currency of existing liabilities”

Answer 6

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.

Question 7

“Term of existing liabilities”

Answer 7

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)

Question 8

6 Considerations with respect to the assets

Answer 8

• 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

Question 9

Free reserves

Answer 9

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

Question 10

Monies not available for investment include (3)

Answer 10

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)

Question 11

7 External influences on investments

Answer 11

• 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

Question 12

2 Insurer-specific investment considerations

Answer 12

• Risk appetite

- Company-specific investment objectives

Question 13

3 Possible insurer situations wrt cahsflow

Answer 13

• 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

Question 14

2 fundamental choices when modelling future liability outgo

Answer 14

• 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, or to determine assets suitable for matching the existing liabilities
• whether to use model point data, which will depend on whether the actual data are too large or difficult to handel.

Question 15

Overall liability outgo can be calculated as (5)

Answer 15

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

Question 16

Claim payment projection must include (4)

Answer 16

• 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

Question 17

4 important considerations in an investment income projection

Answer 17

• 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

Question 18

possible solvency requirements might be related to (4)

Answer 18

• 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.

Question 19

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

Answer 19

• 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

Question 20

5 risks relating to an insurer’s investment strategy

Answer 20

• liquidity
• currency
• market
• credit
• group

Question 21

Liquidity risk

Answer 21

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

Question 22

currency risk

Answer 22

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

Question 23

Market risk

Answer 23

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

Question 24

Economic risk

Answer 24

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

Question 25

Credit risk

Answer 25

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

Question 26

Group risk

Answer 26

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

Question 27

Asset liability modelling (ALM)

Answer 27

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.

Question 28

The basic concept behind ALM (6)

Answer 28

• 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

Question 29

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

Answer 29

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.

Question 30

Why might reporting delays exist with liability insurance?

Answer 30

Potential claims could remain undetected for many years.

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

Question 31

Why might settlement delays exist with liability insurance?

Answer 31

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.

Question 32

5 Suitable assets for a liability insurer

Answer 32

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.

Question 33

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

Answer 33

• 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.

Question 34

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

Answer 34

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.

Question 35

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

Answer 35

• 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)

Question 36

Characteristics of creditor insurance liaiblities

Answer 36

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.

Question 37

9 key considerations in reviewing the investment strategy

Answer 37

• 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.

Question 38

Advantages of stochastic ALM

Answer 38

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)

Question 39

Disadvantages of stochastic ALM

Answer 39

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.

Question 40

Explain the purpose of an ESG within an ALM exercise.

Answer 40

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.