Chapter 22 Flashcards
The Life Insurance Company Setting
*Term life insurance
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.
The Life Insurance Company Setting
*Permanent life insurance
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.
The Life Insurance Company Setting
- whole life insurance
- Universal life insurance
- Variable life insurance
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.
The Life Insurance Company Setting
*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.
Basic Principles of Asset/Liability Management
- 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)
Basic Principles of Asset/Liability Management
Requirements for Investment Returns
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.
Interest Rate Risks
- interest rate risk takes two distinct forms:
- 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.
- 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).
Historical Methods
- Immunization
- 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.
Historical Methods
Limitations of Duration
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.
Emerging Methods and Metrics
Value at Risk (VaR) and Its Brethren
VaR specifies the maximum potential loss over a given time period for a specific chance of occurrence.
The Rise of Derivatives Usage
Derivatives Basics
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.
Best Practices in ALM
Select the Most Appropriate Metric
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.
Interest Rate Risks
A Case Study of Interest Rate Risk
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.
Challenges in Asset/Liability Management
Measurement Basis, Analytical Platform, Communication
Measurement Basis?
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.
Approaches to Asset/Liability Management
Investment Strategy
- Derivative instruments are especially effective in this capacity, because of the powerful risk management attributes they provide.
