Chapter 21: Investments and ALM

Question 1

Components of return to shareholders of an insurer

Answer 1

• an insurance (or underwriting) result
• an investment result (include unrealised capital gains or losses depending on the form of local GAAP)

Question 2

Primary objectives of investment

Answer 2

To maximise the return, subject to:

• the overriding constraint of meeting claim and expense liabilities as they fall due, and
• maintaining a level of solvency compliant with both the statutory regulations and the company’s risk appetite

Question 3

The risk appetite of a general insurer depends on a number of constraints that can be categorised as:

Answer 3

• liabilities
• assets currently held
• external influences
• insurer specific considerations

Question 4

Liability characteristics that need to be considered to identify appropriate matching asset

Answer 4

• nature of the existing liabilities
• currency of the existing liabilities
• term of the existing liabilities
• level of uncertainty of the existing liabilities - amount and timing
• estimated future liabilities arising from the portfolio of business planned
• location of the liabilities
• whether the liabilities are discounted

Question 5

Nature of existing liabilities

Answer 5

Are they fixed or real in monetary terms. Majority of general insurance liabilities are real in nature.

Question 6

Currency of existing liabilities

Answer 6

Many domestic, personal and commercial insurers may have portfolios predominantly denominated in their local currency. However, international insurers and reinsurers have portfolios in a range of different currencies.

Question 7

Term of existing liabilities

Answer 7

Most general insurers’ portfolios are likely to contain a significant proportion of short-term liabilities (1-3 years), with a smaller proportion of medium-term (4-10 years) and long-term liabilities (10+ years)

Question 8

Whether liabilities are discounted

Answer 8

If liabilities aren’t discounted, the net value of assets less liabilities will be subject to movements in the asset values.

Even of assets match the liabilities by term and asset proceeds become available as liability payments are due, the market value of assets may change over time due to changes in interest rates, while liability values won’t change (because liabilities aren’t discounted)

Question 9

Considerations when choosing assets to invest in

Answer 9

• size of the assets in relation to current liabilities
• expected long-term return from various asset classes
• expected volatility within the various asset classes
• existing asset portfolio
• non-investible funds
• economic outlook

Question 10

Free reserves

Answer 10

The excess of the value of an insurer’s assets over its technical reserve and current liabilities.

Question 11

What does the insurer need to compare to the size of its free reserves

Answer 11

• the premiums written each year
• the unpaid claims
• the absolute size of the liabilities the insurer is subject to at any time
• any required statutory minimum solvency margin

Question 12

Non-investible funds

Answer 12

Not all the assets of a general insurer will be available for investment, e.g. monies held by:

• agents (e.g. brokers holding premiums for two months before passing them on)
• policyholders (e.g. premium payments by installment, or end-of-year adjustment premiums due to exposure adjustments or experience rating. Policyholders can be slow to pay their renewal premium)
• reinsurers (e.g. delays in making recoveries)

Question 13

The proportion of non-investible funds depends on:

Answer 13

• the mix of business
• the arrangements with various other parties
• debt collection efficiency

Question 14

External environment considerations when determining the investment strategy

Answer 14

• tax treatment of different investments and tax position of general insurer (relative tax treatment of capital gains vs income)
• statutory, legal, ethical or voluntary investment restrictions
• statutory valuation requirements
• solvency requirements
• rating agency constraints on capital required to maintain insurer’s desired rating and therefore a better image and better terms for raising future capital
• competition - strategy followed by other funds
• regulatory constraints

Question 15

Insurer specific investment considerations

Answer 15

• risk appetite
• company specific investment objectives

Question 16

Possible situations insurers can be in with regards to cashflow

Answer 16

• insurer expects that premiums and investment income will continue to exceed claim payments for the indefinite future
• insurer is in run-off and expects to have to rely on the maturity and realisation of assets
• insurer has suffered a major insurance event and needs to obtain short-term liquidity to settle claims

Question 17

What is the advantage of making some allowance for future new business in the investment strategy of a general insurer?

Answer 17

New premium income can be used to pay short-term liabilities, allowing the existing assets to be invested longer with the aim of producing higher returns.

It’s dangerous to rely heavily on new business because the amount of premium income may be lower than anticipated. This could leave the company exposed to the possibility of having to realise long-term assets to meet short-term liabilities.

Question 18

When an insurer is in run-off, what characteristics would the insurer like the assets to have?

Answer 18

Liquid - close to cash and marketable.

The assets should also have a high running yield (i.e. give a high percentage of their return through income that can be used to meet claims, rather than through capital growth)

Question 19

Fundamental choices when deciding the scope of liability outgo projections

Answer 19

• whether to include premium income and outgo relating to business that will be written after the accounting date, which will depend on whether the exercise is to assess ongoing profitability, solvency and investment policy or to determine assets suitable for matching the existing liabilities
• whether to use model point data, depends on whether the actual data is too large or difficult to handle.

Question 20

Overall liability outgo can be calculated as:

Answer 20

Liability outgo =
total gross claim payments
- reinsurance and other recoveries
+ expenses
- outstanding premiums received
+ tax and dividend payments

Question 21

Claim payment projections must include:

Answer 21

• all future payments in respect of unsettled reported claims
• IBNR and reopened claims
• claims that will emerge from unexpired risks
• claims that will emerge from new business (if chosen to be included in analysis)

Question 22

When projecting investment income, allowance needs to be made for:

Answer 22

• income from investments
• any capital proceeds
• the expenses of investment - usually a negative adjustment to projected asset proceeds
• future volatility of capital values and investment income

Question 23

Solvency requirements insurer will place on itself are likely related to:

Answer 23

• the length of tail
• the likelihood of catastrophes & accumulations
• the spread of risk groups within the portfolio
• the insurer’s experience in writing the class and therefore how predictable the liability outgo is

Question 24

Purpose of a new business projection

Answer 24

Might be to assess:

• the future solvency of the office under different volumes of new business
• the future solvency under different scenarios for asset distributions
• the likely levels of profitability

Question 25

Risks relating to the investment strategy of a general insurer

Answer 25

- liquidity risk - currency risk - market risk - economic risk - credit risk - group risk

Question 26

Liquidity risk

Answer 26

The risk of not having sufficient cash to meet the liabilities as they fall due. More prevalent in longer tail classes for which investments tend to be longer term

Question 27

Currency risk

Answer 27

The risk that changes in the value of the assets, or the liabilities of the company adversely impact the available capital or investment funds.

Question 28

Market risk

Answer 28

The risk relating to changes in the value of the portfolio due to movements in the market value of the assets held.

Question 29

Economic risk

Answer 29

The risk of investing in certain asset classes at certain stages in the economic cycle when the assets are overpriced.

Question 30

Credit risk

Answer 30

The risk that a counterparty to an agreement will be unable or unwilling to fulfil its obligations

Question 31

Group risk

Answer 31

The risk, for example, that an insurance subsidiary might be required to change its investment strategy following a change in the parent's requirements. Liquidity risk might crystalise if, for example, the parent requires a dividend from the subsidiary

Question 32

Asset-liability modelling (ALM)

Answer 32

A term used to describe any model that covers both the assets and liabilities for an entity within one structure. The model projects both asset proceeds and liability outgo simultaneously based on a deterministic or stochastic model

Question 33

The basic concept behind ALM

Answer 33

- project liability outgo in each future time period for a chosen time frame - project asset proceeds (consistently with liability outgo) in each future period - compare the two for each period - run the comparisons again using different assumptions - decide whether the asset proceeds are appropriate for the liability outgo - if not, investigate alternative asset distributions

Question 34

ESG

Answer 34

An ESG will typically take the form of a specialised asset model that stochastically models the performance and interactions of various asset classes The output of this model will be the performance for each economic variable (for example, inflation, asset class returns, GDP, etc.) at each future projection point, for several simulations This table of simulation outputs will then be used within the main ALM as if the ESG was a part of the ALM

Question 35

Reason for separating the ESG and ALM model

Answer 35

An ESG can be a very complex model, the building, parameterisation and running of which is often outsourced Each variable is modelled using specific modelling tools, eg Brownian motion for equity prices, and the outputs include future possible values of each variable ESGs are often viewed as superior as they use common drivers of market risk, such as inflation. Thus the output for each variable is consistent.

Question 36

Stress testing

Answer 36

Involves exposing the chosen strategy to extreme events to check it is robust

Question 37

Scenario testing

Answer 37

Involves developing consistent sets of assumptions that can be used to investigate various assumptions