Chapter 33 - Investment Flashcards
State the 3 main principles of investment for a life insurance company (5)
Principles of investment
- To minimise risk, insurer should select investments that are appropriate to nature, term and currency of liabilities
- Investments should be selected to maximise overall return on assets, including both investment income and capital gains
- 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
List the 4 main asset classes in descending order of (likely) expected return
Main asset classes in descending order of (likely) expected return
- equities and property
- corporate bonds
- government bonds
- cash and money market instruments
What are the key characteristics according to which we consider and compare various asset classes? (7)
We can consider asset types according to the following key “SYSTEM T” characteristics
Spread (volatility)
Yield (return)
Security
Term
Expenses
Marketability
Tax
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)
Why is asset liability matching generally undesirable, and under what circumstances may it be desirable? (2)
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 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?
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
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
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.
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 payment
- 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
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 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: 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,
Describe the approach an insurer could take to developing an investment strategy
- categorise liabilities: guaranteed in terms of monetary/index, investment linked, discretionary
- match investment linked liabilities exactly
- 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
- discretionary benefits
ideally invest in low risk equity and property normally weighted towards equity, because of difficulty associated with property - Free assets
normally invested in riskier equities and property - include sufficient cash
for company to operate on daily basis without need to realise any non cash assets
What impact does free assets have on investment strategy in the context of investment linked benefits? (5)
When it comes to investment linked benefits
- 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.
- Risk of sizeable loss too great, and thus not commonly done, even if the risk can be absorbed by free assets.
- 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.
- Might not be permitted by regulation.
Outline the process for determining an optimal investment strategy using an asset-liability model
1.Model
2.Allocate free assets
3.Stochastics
4.Solvency capital requirement checks
5.Profit measure
6.Repeat
7.Identify
- Using a model of business in force, a model investment portfolio can be built up based on the company’s proposed/current investment strategy
- Allocate adequate proportion of free assets to support underlying reserves
- 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 - 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)
- 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 - 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
