Chapter 33

Question 1

State the principle of investments

Answer 1

(a) In order to minimise risk, a company should select investments that are
appropriate to the nature, term and currency of the liabilities;

(b) 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; subject to an acceptable level of risk

(c) the extent to which the appropriate investments referred to above may be
departed from in order to maximise the overall return will depend, inter
alia, on the extent of the company’s free assets.

Question 2

What investment should back a regular premium with-profits policy halfway through its term (3)

Answer 2

• Government bonds with equal duration i.t.o the liability guaranteed in monetary terms (BE reserve for policy)
• High return assets like equities for the discretionary liability outgo (Excess of ASt)
• AND CASH

Question 3

What investment should back a single premium without-profits inflation-linked annuity (3)

Answer 3

• Index-linked government bonds matching the E(lifetime of annuitant)
• If unavailable, fixed-interest bonds + inflation resilient investment like equities, this must be weighted to simulate the inflation index
• AND CASH

Question 4

What investment should back a unit-linked regular premium savings contract with a guaranteed minimum sum assured (4)

Answer 4

• Invest an amount = Value of the unit-related liability in the underlying assets
• Invest an amount = non-unit part in inflation-linked bonds (for expenses)
• Invest the amount corresponding to the mortality outgo into short-term fixed-interest bonds (maybe for cash convenience)
• AND CASH

Question 5

How to make an investment strategy less risky? (8)

Answer 5

For A backing L:
* increase matching by nature, term or currency
For A in isolation:
* decrease duration (less sensitive to interest rate changes)

For both:
* from corporate bonds to government bonds
* higher credit rated companies
* from new company to established company
* from new sector to established sector

• diversify more
• tradeoff is lower E(profitability)

Question 6

How is an investment strategy set using an Asset–Liability Management (ALM) approach? Also list any risks with this approach

Answer 6

Step 1: Build a Model Office
* Create a model of the business in force.
* Construct a model investment portfolio reflecting the proposed investment strategy.
* Include an appropriate proportion of free assets (not necessarily all of them).

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Step 2: Project Assets and Liabilities
* Project liabilities under assumptions of expected future experience.
* Project assets using a stochastic investment model (to allow for income, capital values, and interest rate/inflation linkages).
* Ensure parameters are consistent (e.g., interest rates, inflation, market values, and liability valuation rates must align).

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Step 3: Test Solvency Over Time
* Value assets and liabilities each year (or continuously, with computational power).
* Check that assets exceed liabilities, plus required solvency capital.
* Define what is a “comfortable” solvency cover (e.g., twice the regulatory minimum, or in line with market norms).

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Step 4: Simulate Market Variability
* Use stochastic simulations (hundreds/thousands of paths) to capture possible investment outcomes.
* Assess the probability of insolvency under each investment strategy.
* Incorporate dynamic liability assumptions if they depend on asset yields (avoid misleading results from fixed assumptions).

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Step 5: Define Success Criteria
* Identify profitability measures to compare strategies (e.g., shareholder profit for proprietary companies, distributed returns for with-profits mutuals).
* Balance risk vs. return:
* Greater ALM mismatch → higher expected returns but higher risk.
* Closer matching → lower risk but lower expected profit

Risks:
* Modelling risk: Results only valid if model + parameters are realistic.
* Free assets treatment: Excluding parts of free assets may distort results; better to model all assets with constraints (e.g., “50% of free assets can be lost with 1% probability”).
* Capital requirement risk: If minimum capital requirement depends on reserves, failing to model it correctly can cause errors.
* Whole-company view: Safer to model the entire insurer (incl. capital requirements + earmarked free assets) for realism.

Question 7

What are the main features of liabilities that affect an insurer’s investment strategy?

Answer 7

• Different tax treatments of different assets affect which assets are invested in
• Large free A = more investment freedom
• With-profits L: if profit distributions are discretionary, this permits investments in real assets
• especially for methods where profit distributions can be deferred
• policyholder expectations => restricted investing => bond investing even for discretionary benefits
• Guaranteed monetary benefits (including any declared attaching bonus benefits), payable on maturity, death and surrender, will require fixed-interest securities
• Annuities in payment will be closely matched by fixed-interest or index-linked bonds, as appropriate to the nature of the annuity benefit
• Assets backing unit-linked liabilities will be invested according to the unit funds chosen by the policyholders
• Any liabilities denominated by foreign currencies are likely to be matched by corresponding foreign currency assets
• Other liabilities that behave similarly to an inflation index (such as expenses) will be matched by index-linked assets and by assets that are expected to provide real returns (such as equities)
• Any shareholders’ liabilities (ie their retained funds) should be invested in real assets in order to maximise returns
• whether the fund is expanding or contracting will affect liquidity requirements
• term of L affects term of A chosen

Question 8

Advantages of ALM

Answer 8

• Prevents losses occurring due to changes in investment conditions
• Lower NB capital requirements
• No need for mismatching reserve
• Reserving basis will require lower margins for investment return
• Products can be priced with smaller margin on investment return parameter=> cheaper premiums => more competitive
• lower cost of capital

Question 9

Disadvantage of ALM

Answer 9

• no profits can be made from favourable investment conditions
• large number of individual holdings could be required which could lead to higher dealing costs
• ALM may just not be possible bc:
• duration of some liabilities could be unknown bc mortality is unknown
• Fixed-interest assets are unlikely ot be available at the exact durations required to produce complete matching

Question 10

What are the limits of immunisation

Answer 10

IMMUNITY
Interest rate changes must be small
Market may lack suitable long-duration assets
Maintenance is continuous
Uncertainty in timing of cfs
No room for high-return assets
Indexation lags cause mismatches (index-linked L)
Transaction costs ignored
Yield curve must be flat

Question 11

How could legislation impact the company’s ability to implement its desired investment strategy? (11)

Answer 11

• Limit ability to match liabilities
• restrictions on the level of assets that may be invested offshore
  *restrictions on the level of assets that may be invested in a particular instrument
• restrictions on the level of assets invested in a specific asset class or currency
• restrictions on type of asset to invest in by class, currency or individual asset
• prescription to invest in certain assets.
• limits on counterparty or credit risk.
• limits on the extent to which a specific asset class may be taken into account to demonstrate solvency.
• minimum credit rating required for bonds
• maximum third party exposure
• solvency capital may be invested into specific assets
• requirement to hold mismatch reserve
• rules on how to value assets
• restrictions on the level of mismatching.
• ESG considerations may need to be applied when selecting investments.
• minimum liquidity requirement
• Tax regulation makes investing in some assets more favourable than others