Chapter 23 Investment

Question 1

Investment: intro

Why is a health insurer’s investment strategy important? (1)

What influences the scale of importance of investment strategy for health care insurers? (2)

Answer 1

• Health Insurer’s investment strategy is importance to its commercial success, financial performance, and security.
• Scale of importance depends on its product(s) and, in particular, the size of the reserves required.
  • Leading on from this, given that a lot of health insurance products will have low reserves, investment strategy becomes slightly less important.

Question 2

State the 3 main principles of investment for a health insurance company (5) and how can these investment principles be summarised (2)?

Answer 2

Principles of investment

1. To minimise risk, insurer should select investments that are appropriate to nature, term and currency of liabilities
2. Investments should be selected to maximise overall return on assets, including botn investment income and capital gains
3. Extent to which ‘appropriate’ investments referred to above may be departed from to maximise overall return will depend, amongst other things, on
   
   1. extent of company’s free assets
   2. company’s risk appetite

Alternatively, principles of investment may be stated as

• company should invest so as to maximise overall return on assets,
• subject to risk taken on being within available financial resources

Question 3

List the 4 main asset classes in descending order of (likely) expected return (4)

Answer 3

Main assset classes in descending order of (likely) expected return

1. equities and property
2. corporate bonds
3. government bonds
4. cash and money market instruments

Question 4

What are the key characteristics according to which we consider and compare various asset classes? (7)

Which is the most important characteristic to consider, and what points do we need to bare in mind regarding this characteristic? (6)

Answer 4

We can consider asset types according to the following key “SYSTEM T” characteristics

1. Spread (volatility)
2. Yield (return)
3. Security
4. Term
5. Expenses
6. Marketability
7. Tax

Of the above characteristics, ‘yield/return’ is the most important, in particular

1. how much expected return will be
2. whether return is real vs nominal
3. split of return between income and capital gain
4. whether running yield sufficient for investors’ needs
5. variance of return
6. tax implications for return

Question 5

In addition to the highly important ‘investment return’ asset class characteristics, what 2 other factors are of key importance? (2)

Answer 5

1. Statutory constraints on insurer holding certain assets
2. Tax implications
   
   • tax reduces returns
   • tax regime may favour investment in particular assets
   • tax regime may favour income over capital gain (or vice versa)

Question 6

Government fixed interest bonds

Discuss characteristics (10)

Answer 6

1. Spread (volatility):
   
   • return not variable, unless not held to redemption, very important when considering matching issues
   • short term market value flactuations with market, eventual redemption unaffected by such fluctuation
2. Yield (return):
   
   • nominal
   • coupon yield similar to money market yield; may also be zero coupon, where running yield is zero, and all of return is capital gain through redemption value
3. Security:
   
   • very secure, most secure asset class other than cash
4. Term:
   
   • depends on market, typical 15 to 20 years
5. Expenses:
   
   • low dealing costs
6. Marketability:
   
   • most marketable and common asset type
7. Tax:

Question 7

Government index linked bonds

Discuss characteristics (9)

Answer 7

1. Spread (volatility)
   
   • return not variable, unless not held to redemption, very important when considering matching issue
   • short term market value flactuations with market, eventual redemption unaffected by such fluctuation
2. Yield (return)
   
   • payments defined in terms of index eg price inflation => impacts returns
3. Security
   
   • very secure, as with fixed interest gov bonds
4. Term
   
   • less variety than gov fixed interest bonds + smaller amounts issues
5. Expenses
   
   • probably low dealing costs, but more expensive than gov fixed interest, as less variety traded
6. Marketability
   
   • lower marketability than gov bonds, because of less variety/smaller amts
7. Tax

Question 8

Corporate fixed interest bonds

Discuss characteristics (9)

Answer 8

1. Spread (volatility)
   
   • non volatile return, if held to maturity
   • market value flactuates with markets, but less important if held to redemption
2. Yield (return)
   
   • higher return than government fixed interest bonds of same term
   • running yield similar to prevailing market interest rates for term concerned
3. Security
   
   • less secure than governemt bonds
   • can be a problem if issuing company not AAA rated
4. Term
   
   • terms similar to government bonds
5. Expenses
   
   • higher dealing
6. Marketability
   
   • lower marketability
7. Tax

Question 9

Equities

Discuss characteristics (13)

Answer 9

1. Spread (volatility)
   
   • volatile income/capital value
   • underlying company itself might go bakrupt/perform badly
   • volatility can be problematic even when holding the asset for long term income, because
     
     • may need to be valued to help demonstrate solvency and
     • when having to redeem it for much less than hoped
2. Yield (return)
   
   • returns (dividend) which would be expected to increase in real terms
   • market value of share also expected to increase in real terms
   • low running yields
3. Security
   
   • underlying company itself might go bakrupt/perform badly
4. Term
   
   • what is the term for an equity? well, can be held in perpituity
   • for matching purposes, discounted mean term is important measure of term, and it is finite for equities
5. Expenses
   
   • usually low dealing costs; depends on how developed market is
6. Marketability
   
   • highly marketable in some markets where equity investments is very developed, but there will also be almost unmarketable stocks
   • in other markets equity investment may not be an option because of the size and reliability of the local market, in which case could consider overseas investment in more mature stock exchanges
7. Tax

Question 10

Property

Discuss characteristics (9)

Answer 10

1. Spread (volatility)
   
   • highly volatile market value, many property markets suffer from some form of cycle
2. Yield (return)
   
   • normally associated with relatively high return
   • income in form of rent; low running yield, should increase in real terms
3. Security
   
   • normally seen as secure, though income stream may suffer occassional interruptions
4. Term
   
   • could be held in perpituity; very long term investment (like equity)
   • unlike equity, option of buying with intent to sell in short term no practical due to impact of dealing costs
5. Expenses
   
   • significant dealing expenses
   • also significant expenses incurred in administering/holding asset
6. Marketability
   
   • very unmarketable
7. Tax

Question 11

Cash

What do we mean by ‘cash instruments’? (1)

Discuss characteristics ( 7)

Answer 11

By cash, we normally mean

• money held on overnight accounts earning spot rates of interest

Investment characteristics of cash

1. Spread (volatility)
   
   • least variable value, especially in the short term
2. Yield (return)
   
   • relatively low return
3. Security
   
   • most secure asset class
4. Term
   
   • usually very short term
   • in fact, because of relatively low term, discounted mean is around zero
5. Expenses
   
   • very low dealing costs
6. Marketability
   
   • very liquid
7. Tax

Question 12

What is perfect liability matching? (1)

Why is asset liabiliity matching generally undesireable, and under what circumstances may it be desireable? (2)

Answer 12

Perfect asset liability matching is when

• assets are chosen whose proceeds are identical to outgo of money being paid out on liabilities, as they occur => would be no investment risk

Desireability/undesireability of asset liability matching

• perfect matching usually undesireable as it removes chance of investment profit
• may be desireable if company has very low free assets such that, without matching, probability of ruin would be unacceptably high

Question 13

What is immunisation? (2)

What conditions must be satisfied in order for a portfolio to be considered as ‘immunized’? (3)

Answer 13

• An alternative to exact matching.
• The aim is the same as that of matching ie protect investor from changes in future interest rates.
• We will have a position of immunisation if :
  
  • PV of liability outgo and the asset proceeds are equal
  • the DMT of liability outgo and the asset proceeds are equal.
  • the spread about the mean term of value of asset proceeds in greater than the spread of the value of liability outgo.

Question 14

What are the limitations of immunisation? (6)

Answer 14

• immunises profits as well as losses
• assets of appropriate nature may not exist
• it may be difficult to immunise against real liabilities
• theory works only with small interest rate fluctuations
• theory assumes when interest rate change, the same change happens at all terms
• you would need to reanalyse the situation everyday.

Question 15

What is the difference between cashflow mistmatching, and risk from short term shocks in investment condidtions? (8)

Answer 15

There is a distinction between cashflow mismatching and risk from short term asset shocks

• cashflow mismatching
  
  • risk over time asset proceeds income less than outgo needed to meet liabilities due to such things as
    
    • having to buy assets in future at lower than expected yields
    • having to sell assets at depressed market values.
  • result of assets liability mismatch by nature, term or currency and its effect unfolds over time as actual cashflows take place (requires cashflow projection to assess mismatch.
• short term asset shocks risk
  
  • relates to whether company would continue to be able to meet its supervisory reserving requirements if market investment conditions were to change suddenly.
  • e.g. change in fixed interest yields or a fall in capital values of equity and property.
  • identify risk, analyse statutory solvency position under different assumptions of current investment conditions.
  • This is known as resilience testing.

Question 16

What are the cornerstone considerations which feed into the asset-liability matching process? (11)

Answer 16

Key cornerstones

• consider liabilities
  
  • currency, uncertainty, nature, term
  • whether we can achive perfect matching with liabilities
  • the level of mismatching we can sustain and its implications
• consider the effect of nature of liabilities on the types of investments held
  
  • for different types of liabilties, how must insurer best invest
  • liabilties might be
    
    • guaranteed in monetary terms
    • in terms of an index
    • indemnity
    • investment linked
• Consider impact of free assets
• Consider regulatory framework

Question 17

What are the constituent parts of the liability outgo of a health insurance company? (5)

Answer 17

Insurer’s liabilities can be split into the following constinuent parts

• benefit payments, expenses, premium income
• expected liability outgo in any year depends on
  
  • the monetary value of each of the constituents and
  • the probability of it being received/paid out

Question 18

Briefly comment on each of the following constituents of the liability outgo of a health insurance company

Ben Pmts (10)

Exp (2)

Prem (2)

Answer 18

benefit payments

• guaranted in monetary terms
  
  • benefits where amount payable specified in contract in money terms.
  • thus includes guaranteed benefit payments under all forms of without profits contracts and the accrued contractual benefits under with profits contracts
• guaranteed in terms of an index of prices or similar
  
  • benefits whose amount is directly linked to such an index
• indemnity
  
  • indicates policies such as PMI where amoutn paid in respect of policyholder is dependent on costs incurred in receiving treatment
• investment linked
  
  • consists of benefits under unit linked and index linked contracts, the amounts of which are determined directly by the value of investments underlying the contracts.

expense outgo

• expense pmts tend to increase at rate not strictly comparable change rate in price or earnings index,
• but for investment purposes, adequate to treat is as being so, hence included in benefit payments guaranteed in terms of index of prices or similar.

premium income

• usually fixed in monetary terms and hence can be thought of as negative benefit payments guaranteed in money terms.
• choice of premium to pay each year does not invalidate this.

Question 19

In an investment context, what do we normally mean by ‘term’ of an asset/liability? (4)

Answer 19

In an investment context, term normally refers to

• concept of discounted mean term (DMT, duration) rather than actual nominal term
• DMT defined as
  
  • weighted sum of the terms of payments
  • where the weight attributed to each term is the present value of the payment at that term. useful in considering an appropriate investment strategy.
• matching liabilities’ DMT with suitable assets results in assets that move in value with the liability in the event of interest rate movements/flactuations

Question 20

In an investment context, what impact does currency/investing oversease play? (5)

Answer 20

Currency also plays a big role in investment strategy​​

• liabilities denominated in certain currency should be matched by assets in same currency, to reduce currency risk
• may also invest overseas
  
  • if liabilities are denominated in that overseas currency
  • for diversification
  • greater returns
  • gain access to different asset classes/types otherwise unavailable

Question 21

Liability nature effects on investment strategy: guaranteed in monetary terms

Discuss how an insurer will invest its assets for liabilities guaranteed in money terms (5)

Answer 21

• Insurer will invest to
  
  • ensure it can meet guarantees
  • this means investing in assets that produce flow of asset proceeds to match liability outgo, taking account of
    
    • term of liability outgo and
    • probability of payments being made
  • applicable to w/o-profits contracts + guaranteed component of w profits

Question 22

Liability nature effects on investment strategy: guaranteed in monetary terms

What type of assets would be best? (4)

Answer 22

Fixed interest assets would be best match

• though exact matching generally won’t be possible, as usually impossible to find assets whose proceeds exaclty match expected liability outgo
• particularly as terms of available fixed interest securities are often much shorter than corresponding liabilities
• a best match is all that can be hoped for

Question 23

Liability nature effects on investment strategy: guaranteed in monetary terms

Comment on the use of immunisation (8)

Answer 23

Immunisation may be useful to match liabilities guaranteed in monetary terms, as insurer would be protected against assets not covering liabilities in event of sudden interest rate moves; but subject to theoretical and practical problems:

• loss of mismatching profits
• difficult to immunise real liabilities
• only works/helps for small interest rate changes
• assumes flat yield curve
• need to rebalance portfolio to immunised position constantly
• assets of required term may not exist
• assets proceeds timing unknown, and liabilities can only be estimated

Question 24

Liability nature effects on investment strategy: guaranteed in terms of index

Discuss how an insurer will invest its assets for liabilities guaranteed in terms of a prices index (5)

Answer 24

• Suitable match would be index-linked securities, where available…
• …ideally chosen to match expected term of liability outgo
• In their absense, invest in assets expected to provide ‘real’ return, eg
  
  • equities
  • properties

Question 25

Liability nature effects on investment strategy: indemnity benefits

Discuss how an insurer will invest its assets for indemnity benefits (5)

Answer 25

Insurer will monitor likely costs arising from various treatments covered by indemnity type contracts

• such contracts usually short-tail contracts with little/no scope for significant investment return because reserves are so small, so mixture of cash and securities such as short-term fixed interest bonds would be suitable
• however, sometimes reserves need to be set up where insurer is aware of future treatment that could persist for some years
  • medical inflation would be a big issue here, which often increases more quickly than standard inflation
  • in this case, common approach => invest in assets giving a “real return” over relatively short period until the case goes off books
    
    • ​index-linked bonds (though medical inflation may be higher than index)
    • can consider equities/properties instead (long term real returns) but bare in mind volatility

Question 26

Liability nature effects on investment strategy: investment linked liabilities

Discuss how an insurer will invest its assets for investment linked liabilities (3)

Answer 26

• such benefits are guaranteed in the sense that their value can be determined at any time in accordance with definite formula, based on value of specified fund of assets (or investment index)
• insurer can avoid investment matching problems by investing in same assets as used to determine benefits
• often regulatory requirement to invest these same assets, if if not, it is normal practic to do so, and would need strong reason to support not doing so
  
  • insurer thought it could profit from such deliberate mismatch (units defined in terms of asset A, insurer thinks asset B will perform better over next 6 months, so assets invested by company to meet unit liabilities are switched from A to B

Question 27

Outline the impact of free assets on investment strategy (4)

Answer 27

Generally speaking

• free assets can be used as a cushion to reduce the probability of becoming insolvent
• allow company to mismatch/depart from matching strategies to improve overall return on its assets and thereby benefit:
  
  • PHs - lower premium/charging rates
  • shareholders (if any) through higher dividends

Question 28

What impact does free assets have on investment strategy in the context of guaranteed liabilities/benefits? (4)

Answer 28

• We expect that assets with highest expected return also have highest variability
• If assets supporting guaranteed benefits were invested in assets with highest expected return, the probability that asset proceeds will become inadequate may be too high for comfort ie. risk of insolvency too great
• Use of free assets is most appropriate in regard to the assets backing guaranteed benefits
  
  • so greater free assets, greater the freedoom in choosing investments for guaranteed liabilities
  • ie the greater the variability of return which the company can accept on backing assets

Question 29

What impact does free assets have on investment strategy in the context of investment linked benefits? (5)

Answer 29

When it comes to investment linked benefits

1. Reasonable use of free assets to mismatch these benefits, if by doing so the company can expect to achieve a higher return. If this is done any return achieved above or below that of the matched assets will not accrue to the unit linked policyholders but to the owners of the company.
2. Risk of sizeable loss too great, and thus not commonly done, even if the risk can be absorbed by free assets.
3. This increase the amount of capital needed to write business (additional reserves to cover mismatching risk needed), which could increase the cost of the product.
4. Might not be permitted by regulation.

Question 30

Describe different controls regulators may implement that should be considerede when setting investment strategy

Answer 30

• Restrict type of assets can invest in
• Restrict amount of a particular type which can be used for purpose demonstrating solvency
• Restrict maximum exposure to single counterparty
• Require a certain proportion of total assets in particular class eg gov stock
• Require to match assets and liabilities by currency
• Requirement to hold mismatching reserve; increasing insurer’s liabilities
• Limit total mismatching allowed at all
• Restrict valuation method of assets
• Restrict who can be a custodian of assets
• NOTE: non-admissible not counted, not allowable can’t invest in
• Matching requirements:
  
  • may require mismatch reserve
  • more risk, higher reserve hence lower free assets.
  • may be required to resilience test
• Other controls:
  
  • can also control assets by controlling investment assumptions required
    
    • certain asset selection may allow a company writing long-term health insurance products to use a higher yield assumption and thereby increase its assets but decrease value of its liabilities
  • may not be able to invest in riskier assets to achieve higher return and thus lower size of reserves

Question 31

What is resilience testing

Answer 31

-Changes in fixed interest yields or a fall in the capital values of equities and property could lead to insolvency. -To identify the risk the company would have to analyse its supervisory solvency position under different assumptions of current investment conditions. -this is referred to as resilience testing.

Question 32

Develop invest strategy: important concepts

List important aspects to be considered/carried out when developing an appropriate investment strategy for a health insurer (7)

Answer 32

1. general approach for developing an investment strategy
2. model office work
3. fund manager assessment
4. liquidity
5. effect on product developing and pricing
6. asset valuation used
7. treating custmers fairly

Question 33

Describe the approach an insurer could take to developing an investment strategy

(Categorise, match, 4)

(Free assets, 3)

(Cash, 1)

(Regulation, 1)

Answer 33

1. categorise liabilities: guaranteed in terms of monetary/index, investment linked, indemnity
   
   • match invesmtent linked liabilities exactly
     
     • invest in assets underlying benefit determination formula
   • match liabilities guaranteed in reference to index
     
     • if possible, if not possible choose nearest thing
   • match liabilities guaranteed in monetary terms
     
     • with government bonds & possibly some corporate bonds of suitable term
   • indemnity benefits
     
     • usually small reserves => minimal scope for investment => cash/short term fixed int assets.
     • sometimes larger reserves for claims which’ll be paid into future + increasing at medical inflation (higher than CPI) => invest to get real returns in that short period
       
       • index-linked bonds (but if index can’t match medical inflation) => equities/properies (considering volatility)
2. free assets
   
   • normally invested in equities and property
   • company can adopt slightly riskier stance than for discretionary benefits in equity selection and could invest overseas without necessarily having to hedge currency risk
   • common to have significant property investment in shape of company’s own premises
3. include sufficient cash
   
   • for company to operate on daily basis without need to realise any non cash assets
4. consider regulation
   
   • any regulatory constraints that may apply

Question 34

Outline the process for determining an optimal investment strategy using an asset-liability model (lots of points…easily 10 marks in an exam))

1. Model
2. Allocate free assets
3. Stochastics
4. Solvency cap req checks
5. Profit measure
6. Repeat
7. Identify

Answer 34

1. Using model of business in force, a model investment portfolio can be built up based on company’s proposed/current investment strategy
2. Allocate adquate proportion free assets to support underlying reserves
   
   • “appropriate proportion”=>determined from asset liability investigations done; only take proportion as
     
     • capital providers may not want all their assets used to support PHs investment strategy (free assets may disappear to pay for any losses arising from mismatch, especially since additonal return earned will be for benefit of PHs)
     • may also be admissibility issues
3. Perform stochastic projections of company’s future assets and liabilities
   
   • use expected future experience for assumptions
   • test variations on these best estimate assumptions
   • for liabilities use
     
     • current basis & project forward to year end on supervisory basis
     • need assumptions to be dynamic & linked to proj basis assumptions
   • project assets forward
     
     • using assumptions for future investment return
     • incorporate stochastic investment model to project future investment income & capital gains/losses + stochastic inflation rate models for future expenses
   • may also account for future new business growth plans, hence future new business strain
   • stochastic proj results will give statistical distribution of amounts available to meet solvency cap requirement, hence calc probability of future insolvency
4. Check excess of assets over liabilities exceeds any minimum capital requirement (or multiple thereof)
   
   • for entire proj period for chosen confidence level (eg 99% of sims)
   • need to identify confidence level, depending on regulatory reqs, nature of business, and level of cover over solvency margin provided by competitors
5. Identify success measure useful to compare invest strategies eg profitabiliity
   
   • proprietary: some measure of distributed profit over future horizon
   • mutual: more difficult, as with profits PHs return matter most)
   • highest expected returns isn’t always most successful, as also depends on how liabilities move…consider overall profit emerging
6. Repeat steps assuming different investment strategies until target probability of insolvency achieved
7. Identify which of the possible strategies, having equal insolvency risk, produces highest profitability

Question 35

List 4 aspects of a health insurer’s financial position that could be investigated using asset-liability modelling (7)

Answer 35

4 aspects of an insurer’s financial position which can be investigated using model office

• Level of riskiness of investment strategy that can be supported
• Level of free assets required to support any business strategy or investment strategy
• Probability of insolvency
• Interdependence between above three aspects
  
  • investment strategy/business strategy/invesment strategy which can be supported while keeping probability of insolvency below an acceptably low figure
• effect on future shareholder earnings (for a proprietary company)
  
  • in particular, investment strat which maximises shareholder income whilst keeping insolvency risk sufficientely low bearing in mind available level of free assets

Question 36

Develop invest strategy: fund manager assessment

Briefly describe how assessing the fund manager (where applicable) forms part of determining a suitable investment strategy for a health insurer (5)

Answer 36

• it is important for the actuary to monitor the results of the fund manager
• results of fund managers should be compared to targets set for overall return and riskiness of strategy undertaken and against performance of other fund managers
• comparisons should be done over several periods where information is available
• where 3rd party managers are involved, regular monitoring is even more important, due to
  
  • less control
  • less access to data

Question 37

Developing invest strategy: liquidity

Describe why liquidity is an important point to be considered when developing an investment strategy suitable for a health insurance company? (3)

In what way does reinsurance feature in this consideration? (2)

Answer 37

Reasons to considser liquidity

• it will be wise to maintain access to ready liquid funds, especially if insurer is
  
  • writing business that can produce claims levels that fluctuate widely, or
  • in run-off

Considerations regarding reinsurance

• even with reinsurance protection the insurer will be left with the obligation to pay gross claims far in advanceof making recoveries from reinsurers.

Question 38

Develop invest strategy: product development/pricing impact

What impact does the investment strategy for an health insurer have on product design and pricing of a healthcare insurer’s insurance contracts? (2)

Answer 38

• company’s ability to invest more widely than its competitors due to possible higher free assets may result in higher overall investment return…
• …this higher overall return on investments which support the liability outgo for any product will enable the actuary to price more competitively

Question 39

Develop invest strategy: asset valuation used

Briefly describe the considerations which go into deciding which asset valuation method to use when determining a suitable investment strategy for a health insurance company? (7)

Answer 39

Method of valuation of assets will depend on the

• the purpose of the exercise, and
• the market’s perception of fair value.

We can consider the asset valuation to use in terms of whether contract is short-term vs long-term

Short-term

• for PMI business which has only-short-term liabilities assets should be valued at market price.

Long-term: for long-term liabilities there are three possibilities

• discount cashflow approach where we discount the likely returns on consistent basis as valuation of liabilities
• use market values as an objective and readily-understood methodology
• if prudence is sought, can use the method from above 2 which produces the lower result for assets

Question 40

Develop invest strategy: treating customers fairly

In what way is the fair treatment of customers an important aspect of the investment strategy determinef for a health insurance company? (3)

Answer 40

• it is unlikely that customers of conventional health and care insurance products have any expectation of investment gains through their insurance.
• however, if insurer experiences underperformance in investment portfolio this may necessitate an increase in premiums, this however would raise questions on TCF.
• regulators would likely not support a price increase being passed to policyholders due to poor investment returns