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 change 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
   
   1. Will link key figures for the insurer, such as investment income, with macroeconomic developments like GDP and the interest rates
   2. Results in a stochastic model of the insurance company that allows you to derive quantities such as the insolvency probability of an insurer
   3. 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
  
  • 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