CHP 27 Flashcards
- Principles of investment
Principles of investment can be stated as follows:
1. Provider should select investment that are appropriate to the
• Nature
• Term
• Currency
Of liabilities and the provider’s appetite for risk
2. Subject to (1) the investments should also be selected so as to maximize the overall return on the assets, where overall return includes both income and capital.
- Asset-liability matching requirements – nature of liabilities
Net liability outgo consists of:
Benefit payments
+ Expense outgo
- Premium / contribution income
In practice the actual liability outgo in any year, or month, depends on
• Monetary value of each of the constituents
• Probability of it being received or paid out.
2.1. Benefit payments
Payments made can be divided into 4 groups:
1. Guaranteed in money terms – outgo is a specified amount.
2. Guaranteed in terms of an index of prices, earnings or similar
Index may not be a published one, e.g. benefits can increase in line with pay awards granted by the sponsoring company.
3. Discretionary – any payments payable at the discretion of the provider, e.g. future bonuses.
4. Investment-linked – amount is directly linked to the value of the underlying assets.
2.2. Expense outgo
Expense payments tend to increase. The natural rate of increase is likely to fall somewhere between price and earnings inflation. In addition there are exceptional items which might be either expenditures or cost savings.
For purpose of investment – treat expenses as linked to prices or earnings. Thus they can be included with benefit payments guaranteed in terms of an index of prices or similar.
2.3. Premium / contribution income
These may be:
• Fixed in monetary terms
• Increase in line with an index
These can be considered as negative benefits of the appropriate nature.
The existence of contracts where the client can vary the amount of premium each year does not invalidate this.
3.1. Guaranteed in money terms
Pure matching
Invest to meet the guarantees, thus invest in assets that produce a flow of proceeds to match liability outgo.
Take into account the term of the liability outgo (timing and amount) and the probability of payments being made.
3.1. Guaranteed in money terms
Approximate matching
Mostly it is impossible to match exactly. (term of asset shorter than liability e.g. pension annuities)
In practice, the best match is selected.
Immunisation – could be used for approximate hedging.
3.2. Guaranteed in terms of a prices index or similar
Ideal asset is index-linked securities, ideally chosen to also match the expected term of the liability outgo.
3.3. Discretionary benefits
The main aim is to maximize returns and thus the investment strategy should aim to do that. Thus invest in assets with the highest expected returns.
3.4. Investment-linked
The benefits are guaranteed to the extent that their value can be found at any time with a definite formula based on the value of a specified fund of assets or index. The provider can avoid any mismatch by investing in the same assets as used to determine the benefits.
Replicating a market index may be done by using CIS or derivative strategy (costly to hold and trade many small holdings in many shares).
3.5. Currency
Match liabilities in a certain currency buy buying assets in that currency.
4.1. Free assets / surplus
Existence of free assets can allow the provider to deviate from the above strategies to improve returns and thus benefits its:
• Clients – higher benefits / lower contribution rates
• Shareholders – higher dividends (subject to some floor / trigger that any surplus is eliminated)
Mostly – highest expected return also has highest variance of returns.
4.1. Free assets / surplus
Guaranteed benefits
Assets to support guarantees are not invested to maximize returns (too high risk of it being inadequate and hence insolvency). This assumes that only enough assets are held so that their expected proceeds will cover the benefits – free assets used to reduce the probability of becoming insolvent.
Using free assets to maintain a deliberate mismatched position has to compete with the other uses of free assets – in particular, financing new business growth. This often means that the opportunities to depart from a matched policy are limited.
4.1. Free assets / surplus
Discretionary benefits
Could argue matching is not required – however there is policyholder expectation about the level of benefits.
Thus the provider will implement a limited matched strategy to ensure that the probability of the assets falling below a certain level is low enough.
4.1. Free assets / surplus
Investment-linked
Often mismatching here is not allowed by law. If allowed – could be done if expected return for the company is high (the additional return will accrue to the company and not the investor).
