Flashcards in Chapter 30 Investment Deck (26):
Conventional bonds characteristics
-loan stock issued & guaranteed by government
-offer nominal returns
-return of asset is not variable when held to redemption.
-considered most secure other than cash.
Index-linked government bonds
-coupon payments will be defined with reference to some index or value such as local price inflation.
-slightly less marketable
-amounts & variety of index-linked bonds issued by gov are often smaller than the conventional bonds.
Corporate bonds characteristics
-loan stock issued and guaranteed by private companies
-higher returns slightly better than government bonds to reflect default risk and lower marketability
-security could be a significant problem especially if company has low credit rating.
-marketability of such bonds is often poor, and dealing cost are high.
-offer an income (dividends) that's expected to increase in real terms.
-risks attached to income and capital value
-company might go bankrupt
-market share is volatile, this can be a problem because equity may be sold for less than hoped for.
-returns are in real terms
-running yield is relatively low but increases in real terms
-seen as secure however income may suffer occasional interruptions.
-market value can vary over the long-term
-less liquid and marketable than other assets
-running costs are quite high
-very long-term investment
-each property is different therefore valuation can be difficult.
-can only be bought in large chunks
-money held overnight accounts earning spot rates of interest.
-most secure type of asset
-least variability in value
-very liquid with dealing costs almost non-existent
-expected return on cash is relatively low and an insurer with long-term liabilities will need to reinvest at unknown rates.
The principles of investment
-a company should select investments that are appropriate to the nature, term and currency of the liabilities.
-investments should also be selected so as to maximise the overall return on assets, where return includes both investment income and capital gains
-the extent to which a) may be departed from in order to meet b) will depend on the extent of the company's free assets and company's risk appetite.
-company must maximise the return subject to the financial resources it has available.
Asset-liability matching requirements
-Nature, term and currency of the liabilities
-Effects of the nature of liabilities
Nature, term and currency of the liabilities
The liability outgo consists of ?
-benefit payments + expense outgo - premium income
-expected liability outgo in any year depends on the monetary value of each of the constituents and the probability of it being received of it being received or paid out.
Nature: Benefit payments can be subdivided into four types.
-Guaranteed in monetary terms: benefit payment is specified in monetary terms in the insurance contract.
-Guaranteed in terms of an index of prices: consists of benefits whose amount is directly linked to such an index.
-Indemnity: indicates policies such as PMI where amoutn paid in respect of policyholder is dependent on costs incurred in receiving treatment.
-investment-linked: consists of benefits where amoutn payable is determined by value of investments.
-also known as discounted mean term
-the DMT of liabilities is important in considering an investment strategy
-when a liability is matched with an asset of the same DMT the insurer will be protected from interest rate fluctuations.
-liabilities denominated in a certain currency should be matched with assets in the same currency, so as to reduce any currency risk.
What is immunisation
-An alternative to exact matching.
-The aim is the same as that of matching ie protect investor from changes in future interest rates.
-We will have a position of immunisation if :
-PV of liability outgo and the asset proceeds are equal
-the DMT of liability outgo and the asset proceeds are equal.
-the spread about the mean term of value of asset proceeds in greater than the spread of the value of liability outgo.
Limitations of immunisation
-immunises profits as well as losses
-assets of appropriate nature may not exist
-it may be difficult to immunise against real liabilities
-theory works only with small interest rate fluctuations
-theory assumes when interest rate change, the same change happens at all terms
-you would need to reanalyse the situation everyday.
Regulatory framework within a country may limit what a company can do in terms of investment. Following controls may be implemented:
-restrictions on the types of assets in which an insurer can invest.
-restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
-restrictions on the maximum exposure to a single counterparty
-a requirement to hold a certain proportion of total assets in a particular class for eg government stock.
- a requirement to match assets and liabilities by currency
-a requirement to hold a mismatching reserve, this will increase the liabilities of the insurer.
-a limit on the extent to which mismatching is allowed at all
-custodianship of assets
-regulatory environment can also affect the choice of assets through their relationship with the investment assumptions used to value liabilities.
-a certain asset selection may allow a company writing long-term health insurance products to use a higher yield assumption and thereby increase its assets but decrease value of its liabilities.
-method required to value the assets.
What is resilience testing
-Changes in fixed interest yields or a fall in the capital values of equities and property could lead to insolvency.
-To identify the risk the company would have to analyse its supervisory solvency position under different assumptions of current investment conditions.
-this is referred to as resilience testing.
Using a model office to determine an investment strategy
-using a model of business in force, a model investment portfolio can be built up based on the company's proposed investment strategy and incorporating appropriate proportion of free assets.
-the liabilities and assets will then be projected forward on assumptions that represent expected future experience, although the company will want also to consider the effect of variations from these.
-for assets, stochastic investment models can be incorporated in order to project future investment income and changes in capital values, Inflation rate models can also be used to project future expenses on the liability side.
-there should be consistency between parameters/assumptions.
-projected value of assets & liabilities can be valued at the end of each year of projection on the company's supervisory basis.
-the item of interest will be excess value of assets over liabilities. Insurer needs to be comfortable with this especially from a regulatory requirement.
-a stocastic investment model and simulation techniques will produce a statistical distribution of amounts available at each year to cover level of SCR. Probablity of future insolvency can be estimated. Each simulation will represent a particular investment strategy.
The insurer will perform AL modelling to test the proposed investment strategies, which could be used to investigate (3):
-riskiness of the investment strategy
-level of the free assets
-probability of insolvency
Other uses of the model office
-simulations could be also used to determine the level of free assets that the company needs in order to support a particular investment strategy & keep probability of insolvency below an acceptably low figure.
-for a proprietary company effect of investment strategy on earnings of shareholders can be assessed.
-it can determine a strategy that maximises shareholder income whilst keeping risk of insolvency relativel low bearing in mind level of free assets.
Fund manager assessment
-it is important for the actuary to monitor the results of the fund manager.
-results of fund managers should be compared to targets set for overall return and riskiness of strategy undertaken and against performance of other fund managers.
-if an insurer is writing business that can produce claims levels that fluctuate widely or if it is in run-off it will be wise to maintain access to ready liquid funds.
-even with reinsurance protection the insurer will be left with the obligation to pay gross claims far in advance of making recoveries from reinsurers.
Effect on product development and pricing
-return on investments to support the liability outgo for any product will enable the actuary to price more competitively.
-company's ability to invest more widely than its competitors due to possible higher free assets may result in higher overall investment return.
-method of valuation of assets will depend on the purpose of the exercise and the market's perception of fair value.
-For PMI business which has only-short-term liabilities assets should be valued at market price.
-for long-term liabilities there are two possibilities.
1.discount the likely returns on consistent basis as valuation of liabilities.
1.Use market values as an objective and readily-understood methodology.