Corubulo's Notes Flashcards
3 Non-actuarial techniques (developing an investment strategy)
- Mean-variance optimisation
- Asset allocations based on market capitalisations
- Shadowing strategies of comparable institutions
4 Actuarial techniques (developing an investment strategy)
- Pure/exact matching
- Asset liability models
- Mean-variance with liabilities
- Liability hedging:
- Full hedging
- Approximate hedging
Pure matching
- Asset proceeds coincide precisely with net liability outgo
- Sensitivity of timing & amounts need to be known with certainty
Restrictions of Pure matching
- Except for fixed liabilities (matched with zero coupon bonds) it is rarely possible in practice.
- Suitable assets might not be available / prohibitively expensive.
It is, however, still useful as a benchmark position.
Full hedging / matching
Liabilities ‘behave’ (ito values, returns, CFs) in the same way as assets in terms of all relevant factors affecting assets and liabilities.
In practice it is achievable in limited circumstances.
- Unit price determined by reference to the portfolio
- It can be difficult if the benchmark is determined externally
- Derivatives (especially OTC) are extensively used
Approximate hedging
Hedging with regards to specific factors:
- Nature (fixed/real)
- Term
- Currency
- Immunisation (interest rates)
Immunisation
- Used when pure matching is not possible
- Invest so that “A-L or A/L” is immune to small interest rate changes
Reddingtons classical theory (immunisation)
- PV(liability outgo) = PV(asset-proceeds)
- DMT(liability outgo) = DMT(asset-proceeds)
- Spread arount DMT of asset-proceeds >= Spread arount DMT of liability outgo
Limitations of immunisation
- Aimed at fixed liabilities
- possibility of mismatching profits removed
- theory relies on small changes in interest rates
- theory assumes flat yield curve + same change in interest rate at all terms
- Requires constant rebalancing of portfolio
- Assets with suitably long DMT may not exist
- Unknown timing of asset proceeds / liability outgo.
Asset-liability models
- Measures risk of not meeting investment objectives
- Allows for variation in assets and liabilities simultaneously
- Usually a stochastic model
- Enables comparison of projected asset proceeds / liability outgo under different strategies to find an optimum strategy
- Encourages investors to formulate explicit objectives
Mean-variance portfolio theory with liabilities
- Extends portfolio theory to take account of investor’s liabilities
- Consider size of surplus at end of a single period
- Use mean-variance theory to minimize variance of surplus for a given expected return
In practice, we need to decide how to determine:
- value of the liabilities versus the assets
- variance and covariance of liabilities with assets
3 Components of overall investment risk
- Strategic (or policy) risk
- Structural risk
- Active (or manager) risk
Strategic (or policy risk)
Risk of poor performance of Strategic Benchmark relative to the Fund’s Liabilities
Structural risk
Strategic benchmark ≠ Aggregate of portfolio benchmarks
Active (or manager) risk
Risk that Managers underperform their portfolio benchmarks
Risk budgeting
Process of setting of risk limits.
Setting an overall risk limit, then deciding how to
… allocate the overall risk limit across all the activities/sources that give rise to investment risk
… in order to maximise overall return within the overall risk limit.
Historic tracking error
SD of difference between returns on portfolio and the benchmark (observed)
Forward looking tracking error
Estimate of future SD based on current portfolio structure, which is based on:
- expected future volatility of stocks / markets vs the benchmark
- expected future correlations between stock / markets
Active money
- Deviation from benchmark portfolio for a specific position
- The closer to zero, the more passive the fund
- Not a complete picture of risk taken on.
Ideal Criteria for a risk to be insurable
- Moral hazard must be avoided as far as possible
- The probability of the event occurring must be small
- Risks must be independent
- There must be a limit on the overall liability on the insurer
- Similar risks must be able to be pooled to reduce the variance and hence achieve more certainty
- There should be sufficient existing statistical data available to enable the insurer to estimate the extent of the risk and its likelihood of occurrence
(not mentioned)
- Policyholder must have a financial interest in the risk
- Risk must be of a financial and reasonably quantifiable nature
- Claim amount must be commensurate with the size of the loss
Why might a motor insurer want to investigate certain claims?
- To ensure that the claim is valid:
- – in terms of the peril covered
- – and the claim amount not being inflated
- Ensure that the claim is in accordance with the policy’s terms and conditions
- Investigate representative samples to help the insurer better understand the risk profile and aid pricing / underwriting
- May help to set new terms and conditions or types of claims (if the risk profile is changing)
- May help in providing advice to the insured on how to avoid (or reduce) claims. I.e. safety & security issues.
Describe the main criterion a company would use to determine whether or not to investigate a particular claim
- amount of the claim
Either actual claim amount or the estimated potential claim amount.
Large claims over a threshold would be investigated.
The rationale being that the potential savings on investigating small claims wouldn’t compensate for the expense, time or hassle involved.
The amount could be a fixed cash value or may be relative to average claim amounts.
Allowance would be needed for inflation of claims cost.
The threshold may vary by type of claim or other rating factor.
Liquidity risk
risk that the individual or company, although solvent, does not have sufficient financial resources available to enable it to meet its obligations as they fall due.
