Chapter 3: Institutional Investors

Question 1

Outline the four tests that an institution is likely to check to ensure that ‘reasonable expectations’ of policyholders have been met, with regard to a policy that has minimum guaranteed benefits.

Answer 1

Policyholder Reasonable Expectations checks:

1. The investment policy follows that stated in the company’s Principles and Practices of Financial Management (a document that UK life companies are required to publish).
2. Over the long term, the investment return should be higher than under a without profits policy.
3. Bonus rates are consistent with material published by the company, taking into account past bonus records.
4. In practice, it is also likely to be important that the company achieves an investment return that is at least as good as its competitors.

Question 2

Describe in high-level terms, what is included in each of the three pillars of the Solvency II capital adequacy requirements.

Answer 2

Solvency II requirements: *

Pillar 1:
sets out valuation methods for assets and liabilities, and two levels of capital requirements that firms will be required to meet: a Solvency Capital Requirement (SCR) and a Minimum Capital Requirement (MCR).

Pillar 2:
includes the supervisory review process, under which each insurance company will be required to carry out an Own Risk and Solvency Assessment (ORSA) and supervisors may decide that a firm should hold additional capital against risks not covered in Pillar 1.

Pillar 3:
is the disclosure and supervisory reporting regime.

Question 3

List the four reasons for introducing the Solvency II requirements in Europe.

Answer 3

Reasons for Solvency II

1. increase the level of harmonisation of solvency regulation across Europe
2. protect policyholders
3. introduce Europe-wide capital requirements that were more sensitive to the levels of risk being undertaken
4. provide appropriate incentives for good risk management.

Question 4

Describe briefly how assets would typically be valued under Solvency II.

Describe briefly how ‘technical provisions’ are calculated under Solvency II.

Answer 4

Asset valuation under Solvency II

Assets are required to be valued at market value, based on readily available market prices in orderly transactions that are sourced independently (i.e. quoted market prices in active markets). If such prices are not available, then mark-to-model techniques can be used – provided these are consistent with the overall market consistent (or ‘fair value’ or ‘economic value’) approach.

Technical provisions under Solvency II

Based on a market consistent approach, technical provisions should represent the amount that the insurance company would have to pay in order to transfer its obligations immediately to another insurance company. The technical provision consists of a best estimate liability and a risk margin.

The best estimate liability is the present value of expected future cashflows, discounted using a ‘risk-free’ yield curve (ie term dependent rates). All assumptions should be best estimate, with no prudential margins.

Question 5

List 16 examples of items that might be contained in the Statement of Investment Principles (SIP) of a typical UK pension scheme.

Answer 5

1. scheme’s funding and investment objectives
2. scheme’s appetite for risk and its approach to managing different risks
3. current investment strategy and expected return
4. policy for selecting investments
5. kinds of investments to be held
6. policy towards sustainable investment / Environmental Social and Governance matters
7. ethical stances
8. balance between different kinds of investments
9. minimum and maximum allocations to different asset classes 10. rebalancing policy
10. liquidity and collateral management policy
11. use of derivatives
12. self-investment restrictions
13. policies on corporate governance and socially responsible investment
14. details of the scheme’s managers, their benchmarks and fees
15. roles and roles and responsibilities of the trustees, investment committee, advisers and managers

Question 6

Describe the ‘money multiplier’ that exists in the commercial banking sector.

Describe how this can lead to inflation.

Answer 6

Money multiplier

A commercial bank that receives a deposit of funds, can hold only a small proportion of this deposit to guard against the deposit being withdrawn, and lend the rest out. The amount held is typically deposited with the central bank or held as notes and coins, whereas the larger part that is loaned to individuals or companies can generate economic activity.

Inflation risk

If there is excessive lending in the economy, which results in too much money chasing goods, this can lead to the prices of those goods rising. This is demand pull inflation.

Question 7

Describe the following three terms with regard to risks that banks face:
* credit risk
* liquidity risk
* margin risk.

Answer 7

Credit risk
This is the risk that loans are not repaid, resulting in losses that must be covered by the bank’s less senior lenders or shareholders.

Liquidity risk
The risk that customers do not act independently but panic and want their money back at the same time, or in the case of a bank which relies on short-term funding through the capital markets, that it is unable to borrow when needed.

Margin risk
The risk that the rate paid for short-term deposits varies while the rate charged on long-term lending remains fixed.

Question 8

If risk capital in the banking sector is regarded as insurance, explain what can be thought of as ‘normal’, ‘disaster’ and ‘catastrophe’ insurance in the bank’s capital structure.

Answer 8

Normal
‘Normal’ insurance is provided in the form of equity capital and/or parent guarantees. The cost of this insurance is the excess return over the risk-free rate which the shareholders require from their investment in stock.

Disaster
‘Disaster’ insurance is provided by the holders of junior debt. The cost of this insurance is the excess yield which the note-holders require over the risk-free rate.

Catastrophe
‘Catastrophe’ insurance is provided by the depositors themselves (who bear the residual risk). In an open market, all other things being equal, the cost of this might be deduced as the difference between the interest rate offered on customer deposits covered by government guarantees and that offered on similar deposits not backed by an insurance programme.

Question 9

List three things that the management of a bank would weigh up when determining the amount of risk that the bank should take.

Answer 9

Three things that affect the risk appetite for a bank

1. the minimum regulatory requirements for the planned level of activity (with a small margin for error)
2. the requirements of the credit rating agencies
3. the internal assessment of the riskiness of the activities to be undertaken.

Question 10

List the four original aims and goals of the Basel accord banking regulations.

List the two main aims of the improvements introduced under ‘Basel II’.

Answer 10

Basel accord aims and goals

1. strengthen the world’s banking system
2. place the world’s banking system in a better position to withstand any future problems in world financial markets
3. provide a more equal basis for competition between banks in different countries
4. remove the incentive for a bank to relocate activities in another country in order to take advantage of its relatively lax regulatory requirements (‘regulatory arbitrage’).

Aims of the Basel II improvements
1. to provide a capital adequacy methodology that is more clearly driven by risk.
2. to reward banks that have developed effective risk measurement / management systems by allowing them to hold less capital than banks with less advanced systems.

Question 11

List nine entities or activities that might be classified as ‘shadow banks’.

Answer 11

Nine shadow bank entities or activities

1. hedge funds
2. money market funds
3. structured investment vehicles
4. credit investment funds
5. exchange-traded funds
6. private equity funds
7. credit insurance providers
8. securitisation
9. finance companies.

Question 12

Describe the 3 main additional risks that shadow banks bring to an economy.

Answer 12

Three main risks from shadow banking

1. Leverage
   — as shadow banks do not have to keep to prescribed minimum levels of capital relative to financial exposure, they tend to have greater leverage and are more exposed to booms and busts; the relative out-performance in boom times is advertised to clients as being superior skill rather than the result of leverage; this leads to more money moving to shadow banks and exacerbates any future financial crisis.
2. Increased systemic risk
   — which in turn increases the risk of future financial crises being worse than they would otherwise have been; this is because the shadow banks operate with greater leverage and are exposed to similar external risks as normal banks.
3. Liquidity risk
   — as there is no access to central banks as the lenders of last resort

Question 13

Describe the four main ‘defining characteristics’ of a hedge fund.

Answer 13

Four main characteristics of a hedge fund

1. Typically only high net worth individuals and institutions can gain access to hedge fund investments
2. The range of the investment universe is much greater, including for example stocks, bonds, property, commodities, credit, currencies and derivatives thereon.
3. The amount of leverage employed is greater. Hedge funds will often use borrowed money to magnify their returns. Sometimes this is necessary because the mispricing the fund seeks to exploit may be very small, and without leverage the resulting fund returns would be unattractive to customers
4. The fee structure: hedge funds normally charge both a fixed fee and a performance-related fee. The incentive fee is usually justified on the basis that returns generated are primarily due to the skill of the manager.

Question 14

Outline six types of objective that might be set by a sovereign wealth fund, to reflect the fact that the fund might not have actual liability cashflows to finance.

Answer 14

Six types of objective for sovereign wealth funds

1. ethical issues
2. political and social issues (eg ‘demographic issues’ such as an aging population)
3. liquidity and marketability requirements
4. maximising future returns
5. to preserve wealth for the future when a natural resource is likely to be depleted
6. economic stabilisation when a country’s wealth relies heavily on the price of a specific commodity.

Question 15

Outline what is meant by liability hedging (from Subject SP5).

Explain why cashflow matching using government bonds can lead to difficulties.

Answer 15

Liability hedging

Choosing assets so that total values of assets and liabilities is same under all circumstances.

Problems when cashflow matching using government bonds include:
1. the assets may not fully cover the liabilities
2. the term of the liabilities may extend longer than the term of available bonds
3. there may be gaps between the maturities of available bonds * there may be a credit risk with government bonds * there is a risk of a change in tax status of government bonds
4. there may be a ‘mark to market’ risk between the valuation of assets and valuation of liabilities.

Question 16

Describe the advantages of using swaps to improve cashflow matching.

Answer 16

The advantages of using swaps

The advantages of using swaps for cashflow matching are:
1. using RPI swaps, the approach can be extended to match inflation-linked liabilities
2. swap durations can be longer than the duration of available bonds
3. swaps can be more liquid than bonds
4. the costs of a swap portfolio can be less than that of a bond portfolio
5. full duration hedging can be achieved even if the scheme is underfunded
6. swaps are flexible, particularly with respect to exact term of the swap.

Question 17

Describe the disadvantages and drawbacks of using swaps for cashflow matching.

Answer 17

The disadvantages of using swaps

The disadvantages of using swaps for cashflow matching are:
1. ISDA agreements can be expensive and time consuming
2. swaps may require collaterisation
3. closing out a swap can be harder than selling a bond
4. counterparty risk exists with the banking counterparties
5. institutions usually pay floating (and receive fixed) which means that the assets have to earn the floating rate − this is not always easy
6. basis risk exists between the swap yield curve and the bond yield curve.

Question 18

Explain the term ‘liability-driven investment’.

Answer 18

Liability-driven investment (LDI)

LDI is not a strategy or a type of product available in the market but an approach to setting investment strategy, where the asset allocation is determined in whole or in part to a specific set of liabilities.

Under an LDI approach it is possible to closely match:
1. the interest rate sensitivity (duration) of the liabilities
2. the inflation-linkage of the liabilities
3. the shape of the liabilities.

Question 19

Describe the different approaches to LDI that different investors may have.

Answer 19

Different approaches to LDI

Some investors will focus on matching cashflows, whereas other will focus more on balance sheet hedging ie aligning asset and liability sensitivities under changes in interest rates and inflation expectations.

The latter approach is likely to result in an investor accepting a degree of cashflow mismatch in return for lower basis risks.

Question 20

Explain how a LDI strategy would be implemented and any risks that may remain.

Answer 20

Implementing a LDI strategy and other risks

Implementing an LDI strategy an investor would expect changes in the value of their assets to closely match changes in the value placed on the liabilities.

A combination of interest rate and inflation bearing assets can provide a close match of projected benefit cashflows, effectively immunising an investor against future changes in interest rates and inflation.

There are many different approaches to managing LDI, although most investors tend to focus on swap portfolios or long duration bond management. It is also possible to use repos to replace swaps in this process.

Non-investment risks such as longevity tend to remain.

Question 21

Give examples of measures used by institutions to combat these other risks.

Answer 21

Dealing with the other risks

Measures include:
1. interest rate or inflation hedging
2. longevity swaps.
3. longevity insurance policies
– exchange fixed payments (‘premiums’ or expected payments to annuitants) in return for floating payments (‘claims’ or actual payments to annuitants).

Question 22

Explain what is meant by each of the following:
* strategic risk
* active risk
* structural risk

Answer 22

Strategic risk:
Risk that strategic benchmark under-performs relative to value of liabilities. Often quantified with reference to matching portfolio – portfolio deemed to most closely match liabilities.

Active risk:
For each individual specialist manager, active risk is risk that he under-performs relative to his particular benchmark. Total active risk is risk that managers in aggregate under-perform relative to aggregate of individual benchmarks.

Structural risk:
Risk that aggregate of individual managers’ portfolio benchmarks under-performs relative to strategic benchmark.