QFIP-154: Evolution of Insurer Investment Strategies for Long-Term Investing

Question 1

Provide a few reason for why life insurance companies and pension funds would want
to invest in long-term assets

Answer 1

Can help close the duration gap for the long-term liabilities (i.e. 30+ years) of life
insurance companies and pension funds

Provide the opportunity to earn higher yields amidst the low interest rate
environment

Liabilities are relatively illiquid, so they can afford to invest in relatively long-term
assets like infrastructure and earn an illiquidity premium

Question 2

Compare and contrast the duration of the liabilities or non-life insurance companies vs.
life-insurers and pension funds, and explain how this impacts their key risks and
investment strategies

Answer 2

Non-life insurance products are typically short-term and have unpredictable liability
cashflows

Main priority is to maintain liquidity
Life insurance companies and pension funds have relatively long-term liabilities and
stable, predictable liability cashflows

Primary risk is a mismatch of duration between assets and liabilities

Can invest in less liquid, long-term assets

Question 3

Describe four ways in which insurers may be taking excessive risks

Answer 3

1. Insurer charges insufficient premiums or has an imprudent underwriting policy
2. Insurers can changer their asset allocation toward a riskier investment portfolio
3. Reduce their equity capital endowment to the minimum regulatory capital
   required, which leads to a higher probability of insolvency
4. May fail to sufficiently manage risks through reinsurance arrangements

Question 4

Describe cash-flow matching, and provide some of its disadvantages

Answer 4

Cash-flow matching attempts to match the maturity of each position in the liability
portfolio directly with cashflows from the assets. However, it has limitations.

Timing and amount of liability claims is often uncertain

Can be costly, since insurers are constrained to only invest in assets based on
their cashflow needs, while foregoing investing in alternative assets with higher
yields

Question 5

Describe some limitations of using duration-matching alone for immunizing the interest
rate risk of a liability

Answer 5

Duration matching only works well if cash flows are known with a high degree of
certainty

Only works well for small changes in the interest rates. When there are large
charges, though, one needs to consider second order effects

If key rate durations are not hedged, then duration matching would only hedge
against parallel shifts of the entire yield curve

Question 6

Describe two different types of scenario analyses for asset-liability management used
by insurance companies

Answer 6

1. Dynamic financial analysis (DFA): Models the insurance company and its
   environmental factors in an integrated manner
   Ÿ Will link key figures for the insurer, such as investment income, with macroeconomic
   developments like GDP and the interest rates
   Ÿ Results in a stochastic model of the insurance company that allows you to derive
   quantities such as the insolvency probability of an insurer
   Ÿ Used primarily by non-life insurance companies
2. Stress testing: Determine the probability of ruin or expected shortfall in diverse,
   extreme scenarios (i.e. such as a large stock price decline)

Question 7

Describe how there are certain liquidity issues for using interest rate swaps and
options to hedge interest rate risk in liabilities

Answer 7

There is not a liquid market for interest rate swaps with tenors greater than 20 years,
and for options with tenors greater than 5 years

This makes it difficult to find long-term, liquid derivatives to hedge all of the interest
rate risk of the long-term liabilities of life insurance companies and pension funds

Question 8

Describe some factors that can create incentives for insurance companies to invest in
long-term assets such as infrastructure

Answer 8

Supervisory discretion to foster long-term and infrastructure investments:
Many jurisdictions have begun encouraging insurance to make more long-term
investments in order to fund important infrastructure projects

Facilitating the creation of appropriate investment vehicles: Makes it easier
for insurers to access long-term investments

Public-private-partnerships: Long-term contractual arrangements between the
government and a private partner
Ÿ Involves fiscal commitments by the government, such as guarantees to compensate
the private property in case the project generates low revenues

Demographic change: Increased life-expectancy will result in longer duration
liabilities

Climate change: To hedge against adverse impact of climate change, insurers
have incentive to invest in green investments

Question 9

Describe some factors that can create disincentives for insurance companies to invest
in long-term assets such as infrastructure

Answer 9

Market consistent valuation: Causes higher volatility in the balance sheet

Capital requirements: Capital charges for long-term investments like
infrastructure projects are relatively high

Expertise: Smaller insurers and pension funds lack the expertise for direct
investment in long-term projects and infrastructure

Lack of high quality data: Makes it difficult to quantify the risks of these projects