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
