Chapter 22

Question 1

The Life Insurance Company Setting

*Term life insurance

Answer 1

Provides what is considered “pure” mortality protection.

In exchange for each premium payment, the insurer provides coverage if death occurs during the premium payment period. Because the chance of death increases as the policyholder ages, premiums will increase as well.

Question 2

The Life Insurance Company Setting

*Permanent life insurance

Answer 2

features a fixed premium that acts to levelize the policyholder’s outlay over the lifetime of the policy.

For a block of policies, the excess of early-year premiums over early-year claims adds to reserves. Thus, a key responsibility of the insurer is to invest the excess premiums at a sufficient rate of return. Because of this, permanent life insurance policies are considered to include what is known as a savings element, which represents the contribution of investment earnings to funding future policy claims.

Question 3

The Life Insurance Company Setting

• whole life insurance
• Universal life insurance
• Variable life insurance

Answer 3

With traditional whole life insurance: an interest rate on reserves is implicit in the premium rate and is locked in at time of policy issuance.

Universal life insurance: in contrast, features a reserve that accumulates at company declared credited interest rates, which are periodically reset.

Variable life insurance: funnels premium dollars into separate accounts – segregated pools of bonds or stocks.

Question 4

The Life Insurance Company Setting

Answer 4

*The two major asset classes in which life insurers invest are bonds and mortgages, because of their long maturities and the fact that most issues pay fixed rates of interest. Because of the latter characteristic, bonds and mortgages are referred to as fixed income investments.

Question 5

Basic Principles of Asset/Liability Management

Answer 5

• ALM recognizes that the financial impact of an asset or liability is mainly realized through its cash flows. An asset or liability can be measured in two different ways.

The value of a particular instrument, whether an asset or an insurance policy, depends on the timing, amount and certainty of its future cash flows and the time value of money. (The foundations of asset/liability management lie in the concept of immunization, which is based on duration)

Question 6

Basic Principles of Asset/Liability Management

Requirements for Investment Returns

Answer 6

Perhaps the strictest return requirement is for policies that make a guarantee of minimum interest rates. For immediate annuities, this is the implicit interest rate defined by the sequence of periodic annuity benefit payments the policyholder is promised.

Question 7

Interest Rate Risks

• interest rate risk takes two distinct forms:

Answer 7

1. Maturity Mismatch Risk: A mismatch in the timing of asset maturities relative to policy benefits requiring either reinvestment or disinvestment by the insurer at uncertain future interest rates.Maturity mismatch risk is categorized according to the relative maturities of assets and liabilities.

• Reinvestment risk: liability CF that extend further into the future (are “longer”) than asset cash flows, which is disadvantageous if the reinvestment is at lower than expected interest rates.
• Capital value risk: liabilities “shorter” than assets, which can lead to the liquidation of assets at depressed values in times of higher than expected interest rates.

2. Option Risk: Assets can contain call or prepayment options (the right to prematurely retire debt at a set value) and liabilities can contain put options (the insured’s right to surrender a policy and receive its cash value).

Question 8

Historical Methods

• Immunization

Answer 8

• The foundations of asset/liability management lie in the concept of immunization, which is based on duration.
• Duration: is a measure of the first-order interest rate sensitivity of a financial instrument. It is intended to quantify the effect on the market value of an instrument of a one-percentage-point change in interest rates. It is a measure only of the change in (asset or liability) economic value attributable to small changes in interest rates.

By quantifying interest rate sensitivity, the duration measure allows ready evaluation of investment risk and can also indicate corrective actions. If durations are matched, a change in the level of interest rates is expected to have the same percentage impact on the values of both assets and liabilities so that surplus will be unaffected.

If asset duration is too low relative to liability duration, lower duration assets must be replaced with higher-duration assets. This is known as lengthening the duration, while the opposite is referred to as shortening the duration.

• immunization requires constant monitoring of the asset and liability durations and rebalancing of the asset portfolio to reestablish the duration match.

Question 9

Historical Methods

Limitations of Duration

Answer 9

Immunization theory does recognize that duration matching requires rebalancing the asset portfolio, but the theoretically correct answer is to rebalance continuously. Frequent rebalancing is impractical and can involve exorbitant transaction costs.

Question 10

Emerging Methods and Metrics

Value at Risk (VaR) and Its Brethren

Answer 10

VaR specifies the maximum potential loss over a given time period for a specific chance of occurrence.

Question 11

The Rise of Derivatives Usage

Derivatives Basics

Answer 11

There are two broad classes of derivatives: futures contracts and option contracts

• Futures contract is an agreement between two counterparties to enter into a particular transaction at a specified date in the future at an agreed-upon price.
• An option contract conveys a right, but not an obligation, to enter into a particular transaction. A call option gives its owner the right to BUY something at an agreed-upon price, while a put option gives its owner the right to SELL something at an agreed-upon price.
• Interest Rate Cap - A call option on an interest rate. The buyer pays a premium to obtain protection against a rise in an interest rate above a predetermined level, the strike rate.
• Interest Rate Floor - A put option on an interest rate. The buyer pays a premium to obtain protection against a drop in an interest rate below a predetermined level, the strike rate.
• Interest Rate Swap - A contractual agreement to exchange one interest rate stream for another.
• Forward Contract - A private agreement to buy or sell a given quantity of an asset such as a currency, interest rate or commodity at a specified future date at a specified price.
• Futures Contract – A standardized, exchange-traded agreement to buy or sell a given quantity of an asset at a specified future date at a specified price.
• Interest Rate Swaption - An option to enter into a swap at a specified date and price.

If an option is in-the-money, so that the owner can buy for less than the current market price (with a call) or sell for more than the current market price (with a put), the option owner can exercise the option.

Question 12

Best Practices in ALM

Select the Most Appropriate Metric

Answer 12

A metric is a measurement standard or yardstick for quantifying ALM risk.

The key criteria for choosing a metric are relevance, or the extent to which the metric captures the nature and extent of an insurer’s risk exposures, and actionability, or how the metric motivates and enables reparative actions.

Question 13

Interest Rate Risks

A Case Study of Interest Rate Risk

Answer 13

An insurer’s greatest exposure to interest rate risk may derive from the single-premium deferred annuity (SPDA).

• Savvy sales agents, acting in the interests of their clients, instigate surrenders of the original policies and placement with the new insurers. This phenomenon is known as disintermediation.

Question 14

Challenges in Asset/Liability Management

Measurement Basis, Analytical Platform, Communication

Measurement Basis?

Answer 14

The purest representation of asset/liability dynamics is instead through economic values.

• *Economic Value: which measure assets and liabilities according to the cash flows they generate.

For an asset traded in the financial markets, the economic value is its market value. Market value is the amount of cash that can be immediately realized.

*For life insurance liabilities: a liability fair value is derived from its future cash flows, adjusted for risk as well as any other relevant economic characteristics.

Question 15

Approaches to Asset/Liability Management

Investment Strategy

Answer 15

• Derivative instruments are especially effective in this capacity, because of the powerful risk management attributes they provide.

Question 16

Approaches to Asset/Liability Management

Product Design

Answer 16

To the extent that a company must maintain adequate sales and inforce volume by issuing products whose design and pricing are dictated at least in some part by competitive considerations rather than economic imperatives, the asset-based approach will play a central role in the overall ALM framework.

• A feasible investment strategy may leave more risk than a company should prudently assume due to the risk-exacerbating features of a particular product.

Question 17

Approaches to Asset/Liability Management

Holism

Answer 17

These focus on risk at the enterprise level, rather than at the product or line-of-business level as has been typical in past ALM practice.

• holism qualifies as a separate approach to ALM because it seeks to identify and exploit existing or potential synergies in a company’s diverse business activities.
• An important recent development, extending the principles and objectives of cash flow testing, is the concept of dynamic solvency testing (DST). DST contemplates a holistic analysis in a multi-scenario framework of all significant factors that can affect an
  insurer’s future financial condition.

Question 18

Approaches to Asset/Liability Management

Reinsurance

Answer 18

Traditional reinsurance relies mainly on the same pooling-of-risks concept as does direct insurance, while reinsurance of investment risk is a form of financial intermediation.
*
• Traditional insurance risks are generally nonsystematic – that is, fluctuations in experience are random and average out over larger populations.
• In contrast, investment risk is largely systematic – all insured risks are strongly affected by certain common influences, like developments in the capital markets.

• Somewhat similar to reinsurance is the type of financing activity termed securitization. This involves selling a stream of contingent revenues to another party, at a discount to the expected value. (Reinsurance, in contrast, involves paying another party to assume a stream of contingent expenses, for a premium over the expected cost.)

Question 19

Emerging Methods and Metrics

Option Pricing

Answer 19

option pricing, the theory of the economic valuation of financial instruments whose cash flows depend on capital market conditions – that is, those containing options.

Option pricing theory dictates that economic valuation of any instrument that is not traded in the market (like an insurance liability) must also adhere to this methodology.

The option price of interest-sensitive liabilities can be determined by averaging the present value of future cash flows over the range of arbitrage-free interest rate scenarios.This technique produces an option-adjusted value that captures the cost of the options included.

• Interest rates are a key element of any option pricing exercise because cash flows are discounted at interest.
• Finally, the “effective duration” measure quantifies the sensitivity of the option price to changes in interest rates.

Question 20

Emerging Methods and Metrics

Dynamic Hedging

Answer 20

This approach, which is analogous to the immunization of interest rate risk, involves establishing a hedge portfolio with equity market sensitivities that match those of the liabilities.

There are five equity market sensitivities usually considered in dynamic hedging.
Delta 
Gamma
Vega
Raho
Theta,

Dynamic hedging requires only that the price or value sensitivities of the hedge portfolio and the liabilities are in alignment.