Investments Flashcards
What are the potential regulations when it comes to investment?
- Restrictions on the types of assets that can be held
- or used to demonstrate solvency and/
- or restrictions on exposures to single counterparties or countries
- A requirement that certain assets are held, e.g. government bonds
- Restrictions on matching:
- a requirement to match by currency,
- a limit on the extent of mismatching and/or
- a requirement to hold a mismatching reserve
- Restrictions on the valuation method or valuation assumptions used
- Restrictions / requirements on the custodianship of assets
- Security classes such as derivatives may not be allowed
- Regulations around investment fees
- Restrictions on international investments
What are the most appropriate investments for PMI?
- Good match: significant investments in cash and short term investment instruments (bonds and money market instruments)
- These types of investments provide a low-risk way to earn a small return on surplus funds while keeping the money accessible for paying claims.
- Premiums and claims payments match each other quite closely, meaning there is not much scope for investments other than short term instruments
- Example: If receive R1m of premium in beginning of the month and R950k claims need to pay during the month, there’s not much money to invest in long term investments.
- In contrast, if the PMI insurer were to invest in longer-term or less liquid assets, such as stocks or real estate, they could face a problem if there was an unexpected surge in claims. They might not be able to sell these investments quickly enough to raise the cash needed to pay claims, or they might have to sell them at a loss.
What are the most appropriate investment for immediate LTC?
- Premiums are paid at the beginning of the policy, which the insurer uses to fund expected future claim payments.
- The insurer is unsure of how long the claim will be paid for, so premium will be invested in mix of longer-term assets to match expected claim payments.
- Need to try earn a stable return, but ensure investments are liquid enough to meet claim payments when they fall due.
What are the most appropriate investment for CI?
- CI policies provide a lump-sum payment upon diagnosis of a covered critical illness, such as cancer, heart attack, or stroke.
- The duration of CI policies is typically longer than PMI policies but shorter than LTC policies.
- Insurers investing CI premiums typically focus on fixed-income securities, such as bonds, with maturities aligned with the expected timing of claims.
- As CI claims are less predictable than LTC claims, insurers may hold a larger proportion of their assets in more liquid investments, such as cash and short-term bonds, to manage unexpected spikes in claims
What are the benefits of matching assets and liabilities?
- This reduces exposure to fluctuations in short term interest rate.
- Can price premiums competitively by using current yields in pricing assumptions to reduce investment risk.
- If free asset levels are low, can help to reduce risk of insolvency.
Investment strategy model
- Decide on various measures (solvency measure, profitability measure, acceptable probability of ruin)
- Allocate portion of free assets to support assets underlying liabilities (crucial for ensuring solvency)
- With the rest of the free assets, project future behaviour of assets.
- This must include investment return assumptions
- Could use market value approach or discounted cashflow approach to value assets.
- Model the behaviour of liabilities.
- Includes any dynamic links to asset behaviour.
- Might include dynamic strategic responses e.g. altering investemnt strategy mid-protection if solvency is in trouble.
- Include expense inflation assumptions in valuations.
- Other model considerations
- Consider the volumes of new business
- Consider the projection period and frequency.
- Model results
- Look at whether the level of assets over liabilities is sufficient to meet solvency capital requirements.
- Run the model with alternative investment strategies.
- Assume different (more or less risky) investment strategies until the target probability of insolvency is achieved
- Identify which of the possible strategies, having equal insolvency risk, produces the highest profitability
- Look at if modelling reveals that outcomes are very sensitive to experience, this should encourage you to keep enough free assets aside to meet short term liabilities.
Is investment assumption important to health insurer?
- Investment returns made on few funds available for investment are not crucial to the financial health of the insurer.
- If reserves are small, whether you invest in equities vs. property etc. doesn’t really matter.
What are the principles of investment?
- A company should select investments that are appropriate to the nature, term and currency of the liabilities
- The investments should also be selected so as to maximise the overall return on the assets, where overall return includes both investment income and capital gains; and,
- The extent to which (a) may be departed from in order to meet (b) will depend, inter alia, on the extent of the company’s free assets and the company’s appetite for risk.
Asset-liability matching
- The aim with matching is to find assets which produce cashflows that are equal and opposite to liabilities in question.
- This is difficult to do perfectly in practice because:
- The insurer may be expanding, so difficult to find asset which produces a negative cashflow initially and is very long term in nature.
- Whilst it does minimise exposure to short term interest rates also lose opportunity to make any profits (or losses) from mismatch.
- As a result the insurer will settle for:
- Trying to get as close as possible by matching the nature, term and currency of liabilities with assets.
- Immunisation which matches the discounted mean term of assets and liabilities
How to match appropriate asset to liability based on its nature
- Liabilities guaranteed in monetary terms
- Immunization theory can be used to build up a suitable portfolio of government bonds, but there are a number of problems and limitations with this approach.
- Normally an appropriate balance between risk and return would be chosen after dynamic asset / liability modelling, in order to allow for free assets.
- Liabilities guaranteed in terms of some non-investment index
- The ideal is to invest in some asset based on the same index or most similar asset available.
- Indemnity liability
- Short-term assets are appropriate for most of these liabilities. There may be some longer-term liabilities that could be matched by real long-term assets.
- Investment-linked liability
- It is normal to invest in the assets underlying the investment link concerned.
What can be done with free assets?
- The more free assets, the more we can depart from a matching strategy to improve overall return.
- This benefits PHs through lower premium rates & shareholders through higher dividends.
- Free assets can be used as a cushion to reduce the probability of insolvency → can invest in higher risk / higher return investments.
- Existence of free assets means that a company can depart from a matched position in order to improve overall investment returns
How should performance of fund manager be assessed?
- Result of fund manager should be tested against:
- The targets originally set for overall return
- The riskiness of the strategy undertaken
- The performance of other fund managers with similar investment briefs
- Where possible, the assessment should be over several such periods to eliminate the effects of luck
Investment strategy for pre-funded LTC product.
Assets need to match by nature, term, currency √
Pre-claim:
* For the benefits guaranteed in money terms, fixed interest bonds would be the best match√.
* For closest matching these should have low default risk√, e.g. government bonds√
* The cashflows arising from the bonds should be matched by term to the expected liability cashflow profile but there may not be any bonds of a sufficiently long term√ in which case an alternative would be to seek an immunised approach√
* For the indemnity based business, the benefits will be both a long time in the future√ and highly uncertain√ in amount – so perfect matching will not be possible√
* One approach might be to invest in assets offering a “real” return, such as equities√
* For both forms, if the benefit is payable in the domestic currency, the assets should also be denominated in the domestic currency √
Expenses:
* Inflation linked assets to match expenses√.
* These could be government index- linked bonds√, but as these particular expenses are likely to be closely linked to salary inflation√, and may be many years in the future; equities may be a better match√.
Premia:
* Also need to take account of expected future premium income, e.g. when calculating the discounted mean term. √
Post claim:
* The benefits will be of much shorter duration√
* Liquidity will be much more of an issue√
* Best match will be made up of some government bonds√, and some cash type investments√
* For indemnity benefits, may still want some inflation linked assets√, however equities are unlikely to be appropriate given the short duration of long term care√ claims so index-linked bonds may be used instead and we also still have some expenses to match with inflation linked assets √
* The company should try to diversify its assets provided it can still be matched √
