Chapter 21: Investments and ALM Flashcards
Components of return to shareholders of an insurer
- an insurance (or underwriting) result
- an investment result (include unrealised capital gains or losses depending on the form of local GAAP)
Primary objectives of investment
To maximise the return, subject to:
- the overriding constraint of meeting claim and expense liabilities as they fall due, and
- maintaining a level of solvency compliant with both the statutory regulations and the company’s risk appetite
The risk appetite of a general insurer depends on a number of constraints that can be categorised as:
- liabilities
- assets currently held
- external influences
- insurer specific considerations
Liability characteristics that need to be considered to identify appropriate matching asset
- nature of the existing liabilities
- currency of the existing liabilities
- term of the existing liabilities
- level of uncertainty of the existing liabilities - amount and timing
- estimated future liabilities arising from the portfolio of business planned
- location of the liabilities
- whether the liabilities are discounted
Nature of existing liabilities
Are they fixed or real in monetary terms. Majority of general insurance liabilities are real in nature.
Currency of existing liabilities
Many domestic, personal and commercial insurers may have portfolios predominantly denominated in their local currency. However, international insurers and reinsurers have portfolios in a range of different currencies.
Term of existing liabilities
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)
Whether liabilities are discounted
If liabilities aren’t discounted, the net value of assets less liabilities will be subject to movements in the asset values.
Even of assets match the liabilities by term and asset proceeds become available as liability payments are due, the market value of assets may change over time due to changes in interest rates, while liability values won’t change (because liabilities aren’t discounted)
Considerations when choosing assets to invest in
- size of the assets in relation to 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
Free reserves
The excess of the value of an insurer’s assets over its technical reserve and current liabilities.
What does the insurer need to compare to the size of its free reserves
- the premiums written each year
- the unpaid claims
- the absolute size of the liabilities the insurer is subject to at any time
- any required statutory minimum solvency margin
Non-investible funds
Not all the assets of a general insurer will be available for investment, e.g. monies held by:
- agents (e.g. brokers holding premiums for two months before passing them on)
- policyholders (e.g. premium payments by installment, or end-of-year adjustment premiums due to exposure adjustments or experience rating. Policyholders can be slow to pay their renewal premium)
- reinsurers (e.g. delays in making recoveries)
The proportion of non-investible funds depends on:
- the mix of business
- the arrangements with various other parties
- debt collection efficiency
External environment considerations when determining the investment strategy
- tax treatment of different investments and tax position of general insurer (relative tax treatment of capital gains vs income)
- statutory, legal, ethical or voluntary investment restrictions
- statutory valuation requirements
- solvency requirements
- rating agency constraints on capital required to maintain insurer’s desired rating and therefore a better image and better terms for raising future capital
- competition - strategy followed by other funds
- regulatory constraints
Insurer specific investment considerations
- risk appetite
- company specific investment objectives
Possible situations insurers can be in with regards to cashflow
- 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 to settle claims
What is the advantage of making some allowance for future new business in the investment strategy of a general insurer?
New premium income can be used to pay short-term liabilities, allowing the existing assets to be invested longer with the aim of producing higher returns.
It’s dangerous to rely heavily on new business because the amount of premium income may be lower than anticipated. This could leave the company exposed to the possibility of having to realise long-term assets to meet short-term liabilities.
When an insurer is in run-off, what characteristics would the insurer like the assets to have?
Liquid - close to cash and marketable.
The assets should also have a high running yield (i.e. give a high percentage of their return through income that can be used to meet claims, rather than through capital growth)
Fundamental choices when deciding the scope of liability outgo projections
- 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 and investment policy or to determine assets suitable for matching the existing liabilities
- whether to use model point data, depends on whether the actual data is too large or difficult to handle.
Overall liability outgo can be calculated as:
Liability outgo =
total gross claim payments
- reinsurance and other recoveries
+ expenses
- outstanding premiums received
+ tax and dividend payments
Claim payment projections must include:
- 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 (if chosen to be included in analysis)
When projecting investment income, allowance needs to be made for:
- income from investments
- any capital proceeds
- the expenses of investment - usually a negative adjustment to projected asset proceeds
- future volatility of capital values and investment income
Solvency requirements insurer will place on itself are likely related to:
- the length of tail
- the likelihood of catastrophes & accumulations
- the spread of risk groups within the portfolio
- the insurer’s experience in writing the class and therefore how predictable the liability outgo is
Purpose 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
- the likely levels of profitability
Risks relating to the investment strategy of a general insurer
- liquidity risk
- currency risk
- market risk
- economic risk
- credit risk
- group risk
Liquidity risk
The risk of not having sufficient cash to meet the liabilities as they fall due. More prevalent in longer tail classes for which investments tend to be longer term
Currency risk
The risk that changes in the value of the assets, or the liabilities of the company adversely impact the available capital or investment funds.
Market risk
The risk relating to changes in the value of the portfolio due to movements in the market value of the assets held.
Economic risk
The risk of investing in certain asset classes at certain stages in the economic cycle when the assets are overpriced.
Credit risk
The risk that a counterparty to an agreement will be unable or unwilling to fulfil its obligations
Group risk
The risk, for example, that an insurance subsidiary might be required to change its investment strategy following a change in the parent’s requirements. Liquidity risk might crystalise if, for example, the parent requires a dividend from the subsidiary
Asset-liability modelling (ALM)
A term used to describe any model that covers both the assets and liabilities for an entity within one structure.
The model projects both asset proceeds and liability outgo simultaneously based on a deterministic or stochastic model
The basic concept behind ALM
- project liability outgo in each future time period for a chosen time frame
- project asset proceeds (consistently with liability outgo) in each future period
- compare the two for each 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
ESG
An ESG will typically take the form of a specialised asset model that stochastically models the performance and interactions of various asset classes
The output of this model will be the performance for each economic variable (for example, inflation, asset class returns, GDP, etc.) at each future projection point, for several simulations
This table of simulation outputs will then be used within the main ALM as if the ESG was a part of the ALM
Reason for separating the ESG and ALM model
An ESG can be a very complex model, the building, parameterisation and running of which is often outsourced
Each variable is modelled using specific modelling tools, eg Brownian motion for equity prices, and the outputs include future possible values of each variable
ESGs are often viewed as superior as they use common drivers of market risk, such as inflation. Thus the output for each variable is consistent.
Stress testing
Involves exposing the chosen strategy to extreme events to check it is robust
Scenario testing
Involves developing consistent sets of assumptions that can be used to investigate various assumptions
