Chapter 30: Investments

Question 1

List the 3 main investment principles

Answer 1

investments selected should be appropriate to nature, term (ie discounted mean term) and currency of liabilities

investments should be selected to maximise overall return, including both investment income and capital gains

the extent to which (1) may be departed for (2) will depend on, amongst other things, the insurer’s free assets and risk appetite

Question 2

How can the nature of liability (benefit payments/ expenses) be grouped?

Answer 2

liability guaranteed in monetary terms
index-linked liability
investment-linked liability
discretionary liability

Question 3

Describe an overall investment strategy

Answer 3

invest away from a matched position, to the maximum extent possible consistent with the desired level of risk and free assets position, in order to maximise returns for shareholders and with-profits policyholders

insurer will perform asset/liability modelling to investigate:
level of riskiness of investment strategy that can be supported
level of free assets required to support investment strategy
resulting proability of insolvency

Question 4

List the factors to consider in assessing appropriateness of investment strategy

Answer 4

main investment principles
free assets position - influences the extent of mismatching

availablity of assets: developing vs developed area
asset characteristics: marketability, liquidity, expenses, volatility of returns, tax

competition: consider investment strategy for similar products, are they disclosed, are they relevant - similar product features

regulation

Question 5

Describe how asset/ liability modelling is used to assess the appropriateness of investment strategy

Answer 5

decide on outcome to be measured - eg probability of insolvency
decide on appropriate projection period

assumptions for liabilities and assets are needed - should be best estimate estimations
liability assumptions:e g morbidity assumptions
asset assumptions: eg expected returns (can be modelled stochastically), correlations, tax rates

liability projection can be based on on a policy-by-policy basis, or use model points representing in-force/ new business
asset projection can be based on proposed asset selection within current investment strategy

for each simulation, net cashflows can be projected at different projection points within the projection period
large number of simulations should be conducted to ensure a credible analysis
if the meaured outcome is inappropriate (ie probability of insolvency too high) then insurer should consider changing investment strategy

Question 6

List investment restrictions

Answer 6

Restrictions on the types of asset allowed
Restrictions on the amount of any particular asset that can be considered when demonstrating solvency
Restriction to match assets and liabilities by currency, term etc
Requirement to invest a minimum proportion of assets in certain asset class
Restrictions on the maximum exposure to single counterparty
Limit to the extent mismatching is allowed
Requirement to set up a mismathing reserve
Restrictions on the custodianship of assets
Restrictions on international investments

Question 7

Suggest appropriate assets to match the following (nature of) liabilities:

fixed benefits
index-linked benefits (linked to price inflation)
index-linked benefits (linked to wage inflation)
insurer’s expenses

Answer 7

fixed benefits:
matched by fixed-interest govt/ corporate bonds of suitable term
higher expected return for corporate bond - higher liquidity risk (no issue if held to maturity) and default risk

index-linked benefits (linked to price inflation):
matched by cpi-linked govt/ corporate bonds of suitable term
higher expected return for corporate bond - higher liquidity risk (no issue if held to maturity) and default risk
equity and property can be used to match long-term liabilities for which there are insufficient bonds with required matching term
equity and property market values quite volatile in the short to medium term (can be offset to a limited extent through diversification - may need to consider indirect propery investment), with their income streams less so

index-linked benefits (linked to wage inflation):
matched by high quality real-return assets such as property and equity
equity and property market values quite volatile in the short to medium term (can be offset to a limited extent through diversification - may need to consider indirect propery investment), with their income streams less so
cpi-linked bonds can be used to match short-term liabilities

insurer’s expenses likely to be real in nature:
likely to be between price and wage inflation
matched by high quality real-return assets such as property and equity

Important to note:
cash needed for working capital
returns on bonds are realised if held to maturity

consider insurer size and the advantages (diversification, cheaper - expenses associated with direct investment avoided, may be more marketable than underlying assets, tax advantages) of indirect investment through collective investment vehicles
consider suitability of foreign assets (provide diversification benefit), managing currency risk through hedging instruments