Chapter 33-Investment Flashcards
State the 3 main principles of investment for a life insurance company (5) and how can these investment principles be summarised (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 both 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
+extent of company’s free assets
+company’s risk appetite
Alternatively, principles of investment may be stated as
(1) company should invest so as to maximise overall return on assets,
(2) subject to risk taken on being within available financial resources
List the 4 main asset classes in descending order of (likely) expected return (4)
Main asset classes in descending order of (likely) expected return
(1) equities and property
(2) corporate bonds
(3) government bonds
(4) cash and money market instruments
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)
We can consider asset types according to the following key “SYSTEM T” characteristics
Spread (volatility) Yield (return) Security Term Expenses Marketability Tax
Of the above characteristics, ‘yield/return’ is the most important, in particular
+how much expected return will be
+whether return is real vs nominal
+split of return between +income and capital gain
+whether running yield sufficient for investors’ needs
+variance of return
+tax implications for return
In addition to the highly important ‘investment return’ asset class characteristics, what 2 other factors are of key importance? (2)
Statutory constraints on insurer holding certain assets
Tax implications
+tax reduces returns
+tax regime may favour investment in particular assets
+tax regime may favour income over capital gain (or vice versa)
Government fixed interest bonds
Discuss characteristics (10)
Spread (volatility):
+return not variable, unless not held to redemption, very important when considering matching issues
+short term market value fluctuation with market, eventual redemption unaffected by such fluctuation
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’
Security:
+very secure, most secure asset class other than cash
Term:
depends on market, typical 15 to 20 years
Expenses:
low dealing costs
Marketability:
most marketable and common asset type
Tax:
Government index linked bonds
Discuss characteristics (9)
Spread (volatility)
real return not variable, unless not held to redemption, very important when considering matching issue
short term market value fluctuations with market, eventual redemption unaffected by such fluctuation
Yield (return)
payments defined in terms of index eg price inflation => impacts nominal returns
Security
very secure, as with fixed interest gov bonds
Term
less variety than gov fixed interest bonds + smaller amounts issues
Expenses
probably low dealing costs, but more expensive than gov fixed interest, as less variety traded
Marketability
lower marketability than gov bonds, because of less variety/smaller amts
Tax
Corporate fixed interest bonds
Discuss characteristics (9)
Spread (volatility)
non volatile return, if held to maturity
market value fluctuates with markets, but less important if held to redemption
Yield (return)
higher return than government fixed interest bonds of same term
running yield similar to prevailing market interest rates for term concerned
Security
less secure than government bonds
can be a problem if issuing company not AAA rated
Term
terms similar to government bonds
Expenses
higher dealing
Marketability
lower marketability
Tax
Equities
Discuss characteristics (13)
Spread (volatility)
+volatile income/capital value
+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
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
Security
+underlying company itself might go bankrupt/perform badly
Term
+what is the term for an equity? well, can be held in perpetuity
+for matching purposes, discounted mean term is important measure of term, and it is finite for equities
Expenses
+usually low dealing costs; depends on how developed market is
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
Property
Discuss characteristics (9)
Spread (volatility)
+highly volatile market value, many property markets suffer from some form of cycle
Yield (return)
+normally associated with relatively high return
income in form of rent; low running yield, should increase in real terms
Security
+normally seen as secure, though income stream may suffer occasional interruptions
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
Expenses
+significant dealing expenses
also significant expenses incurred in administering/holding asset
Marketability
very unmarketable
Cash
What do we mean by ‘cash instruments’? (1)
Discuss characteristics ( 7)
By cash, we normally mean
money held on overnight accounts earning spot rates of interest
Investment characteristics of cash
Spread (volatility)
+least variable value, especially in the short term
Yield (return)
+relatively low return
Security
+most secure asset class
Term
+usually very short term
in fact, because of relatively low term, discounted mean is around zero
Expenses
+very low dealing costs
Marketability
+very liquid
What is perfect liability matching? (1)
Why is asset liability matching generally undesirable, and under what circumstances may it be desirable? (2)
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
Desirability/undesirability of asset liability matching
+perfect matching usually undesirable as it removes chance of investment profit
+may be desirable if company has very low free assets such that, without matching, probability of ruin would be unacceptably high
What is the difference between cash flow matching risk and short term asset shock risk?
cash flow 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 cash flows take place (requires cash flow 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.
What are the constituent parts of the liability outgo of a life company? (3)
Insurer’s liabilities can be split into the following constituent parts
+benefit payments,
+expenses,
+premium income
List four categories in which liabilities can be split according to the nature of the payments involved?
Give an example of a payment type falling in each category?
(1) guaranteed in monetary terms
+this includes guaranteed benefit payments under all forms of without profits contracts and the accrued contractual benefits under with profits contracts
+premium payments treated as negative liability outgo
(2) guaranteed in terms of an index of prices or similar
+benefits whose amount is directly linked to such an index
+inflation linked contracts and expenses payments
(3) discretionary
+Consist of future bonus payments under with profits contracts and surrender values where these are not guaranteed.
+Level of discretion will depend upon bonus distribution method used.
(4) 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.
In an investment context, what do we normally mean by ‘term’ of an asset/liability? (4)
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 liability DMT with suitable assets results in assets that move in value with the liability in the event of interest rate movements/fluctuations
In an investment context, what impact does currency/investing overseas play? (5)
+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
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)
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
Fixed interest assets would be best match though exact matching generally won’t be possible,
usually impossible to find assets whose proceeds exactly match expected liability outgo
particularly as terms of available fixed interest securities are often much shorter than corresponding liabilities
Liability nature effects on investment strategy: guaranteed in monetary terms
Comment on the use of immunisation (8)
Immunisation may be useful but subject to theoretical and practical constraints
loss of mismatching profits
difficult to immunise real liabilities
only works/helps for small interest rate changes
assumes flat yield curve
need to re balance portfolio to immunised position constantly
assets of required term may not exist
assets proceeds timing unknown, and liabilities can only be estimated
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)
Suitable match would be index-linked securities, where available…
…ideally chosen to match expected term of liability outgo
In their absence, invest in assets expected to provide ‘real’ return, eg
equities and property
Liability nature effects on investment strategy: discretionary benefits
Discuss how an insurer will invest its assets for discretionary benefits (6)
Main aim when investing for discretionary benefits is to maximise discretionary benefits,
so invest in assets producing highest expected return
Recipients of discretionary benefits usually expect proceeds of contracts to maintain value in ‘real’ terms.
So invest in assets expected to give ‘real return’
Given these considerations, common approach is to invest in ‘blue-chip’ equities and property
Liability nature effects on investment strategy: discretionary benefits
How might the balance between discretionary (non-guaranteed) and guaranteed benefits impact investment strategy? (5)
Balance between discretionary/guaranteed benefits may also impact investment
bonus philosophy of company
low guaranteed benefits/more terminal bonuses => more equities, worried about matching only closer to policy maturity
level of free assets
risk appetite of company
published investment strategy
insurer’s view of relative performance of various asset
Liability nature effects on investment strategy: investment linked liabilities
Discuss how an insurer will invest its assets for investment linked liabilities (3)
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,
Outline the impact of free assets on investment strategy (4)
free assets can be used as a cushion to reduce the probability of becoming insolvent
Allows company to mismatch/depart from matching strategies to improve overall return on its assets and thereby benefit:
Policyholders - through higher bonuses, or lower premium/charging rates
shareholders (if any) through higher dividends
Describe the approach an insurer could take to developing an investment strategy
(Categorise, match, 4)
(Free assets, 3)
(Cash, 1)
(1) categorise liabilities: guaranteed in terms of monetary/index, investment linked, discretionary
(2) match investment linked liabilities exactly
(3) match liabilities guaranteed in reference to index if possible, if not possible choose nearest thing
(4) match liabilities guaranteed in monetary terms with government bonds & possibly some corporate bonds of suitable term
(5) discretionary benefits
ideally invest in low risk equity and property normally weighted towards equity, because of difficulty associated with property
(6) Free assets
normally invested in riskier equities and property
(7) include sufficient cash
for company to operate on daily basis without need to realise any non cash assets
Outline the process for determining an optimal investment strategy using an asset-liability model (lots of points…easily 10 marks in an exam))
- Model
- Allocate free assets
- Stochastics
- Solvency capital requirement checks
- Profit measure
- Repeat
- Identify
(1) Using a model of business in force, a model investment portfolio can be built up based on the company’s proposed/current investment strategy
(2) Allocate adequate proportion of free assets to support underlying reserves
(3) Perform stochastic projections of a company’s future assets and liabilities on a statutory valuation basis
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 projections results will give a statistical distribution of amounts available to meet solvency capital requirement, hence calculate the probability of future insolvency
(4) Check excess of assets over liabilities exceeds any minimum capital requirement (or multiples thereof) for the entire projection period for chosen confidence level (eg 99% of sims)
(5) Identify success measure useful to compare investment strategies eg profitability
proprietary: some measure of distributed profit over the future horizon
highest expected returns aren’t always most successful, as also depends on how liabilities move…consider overall profit emerging
(6) Repeat steps assuming different investment strategies until the target probability of insolvency achieved
Identify which of the possible strategies, having equal insolvency risk, produces the highest profitability
List 4 aspects of a life insurer’s financial position that could be investigated using asset-liability modelling (5)
Level of riskiness of investment strategy that can be supported
Level of free assets required to support any business strategy
Probability of insolvency
interdependence between above three aspects
