DEVELOPING AN INVESTMENT STRATEGY (1)
1. Asset-liability matching requirements
The net liability outgo consists of:
Benefit payments + Expense outgo – Premium / Contribution income.
a) Benefit payments
The benefit payments can be sub-divided into four types:
1. Guaranteed in money (nominal) terms
2. Guaranteed in terms of an index
E.g. the benefits accruing under a benefit scheme may increase in line with pay awards
3. Discretionary
This is payable at the discretion of the provider, e.g., future bonus payments under with-profit
contracts or pension increases in excess of guaranteed amounts.
But bonuses are not entirely at the discretion of the provider.
The payment and level of bonuses may have become part of PRE.
In this light, bonuses might be regarded partly as being linked to an index and partly as discretionary.
4. Investment-linked
b) Expense outgo
Expense payments tend to increase. The natural rate of increase is likely to fall somewhere between
price and earnings inflation.
Hence expenses can be included with benefit payments guaranteed in terms of an index of prices.
c) Premium / contribution income
Fixed in monetary terms
Increase in line with an index
2. Asset-liability matching requirements – selecting the assets
a) Guaranteed in money terms (fixed assets, use following techniques)
Pure matching: Term and Probability of liabilities matched with flow of assets
Approximate Matching: For some assets, it would be hard to match expected liability
outgoes exactly.
Immunisation: The technique of immunisation may be used to achieve this, but it is
subject to theoretical and practical problems, and it is more complicated.
Immunisation and liability hedging are “technically superior” approaches
b) Guaranteed in terms of a prices index or similar (long term equities, index linked assets)
Assets that provide a good real return (e.g. long term investment in equities)
Equity returns behave to some extent in line with price inflation in the long run, and
so they offer a reasonable match for index linked liabilities
c) Discretionary benefits (Highest return assets)
The main aim of the provider will be to maximise returns, thus invest in assets with
highest expected return.
The recipients of the discretionary benefits will expect the value of benefits to
maintain their value in real terms.
d) Investment-linked (Assets replicating benefit index, CIS’s & derivatives)
The benefits are guaranteed to the extent that their value can be determined at any
time in accordance with a definite formula or index.
The provider can avoid any investment mismatching problems by investing in the
same assets as used to determine the benefits.
Appropriate assets are those which replicate, or closely approximate the index.
Free assets may be used to maximise returns with any profit benefiting the provider.
However, regulation may disallow mismatching. Where the benefits are linked to an
index, replicating a market index may involve holding a large number of small
holdings and thus be too costly.
Companies might choose to use CIS or a derivative strategy to achieve this.
e) Currency
Free assets/surplus
The existence of free assets or a surplus means that the provider can depart from the matching
strategies and thereby benefit:
- Clients, through higher benefits or lower premium rates
- Shareholders, through higher dividends
Guaranteed benefits
Using free assets to maintain a deliberately mismatched policy has to compete with other uses of free
assets, in particular financing new business growth. This often means that the opportunities to depart
from a matched policy for the guaranteed liabilities are limited.
Discretionary benefits
The provider will want to make use of some of the free assets/surplus to ensure that the probability of
the discretionary benefits falling below a particular level stays within acceptable limits.
Investment-linked
By use of the free assets/surplus to mismatch investment-linked benefits, the company can expect to
achieve a higher return. If this is done any return achieved above that on the “matched” assets will not
accrue to the beneficiaries but to the provider.
Regulatory Framework
The following controls may be implemented by regulatory bodies:
1. Matching related:
Requirement to hold a mismatching reserve
Limit on extent of mismatching
Requirement to match A / L’s by currency
2. Restrictions on the types of assets that can be used for investment
3. Requirement to hold a certain % of total assets in a particular class e.g. govt. stock
4. Restrictions on the amount of any particular type of asset that can be taken into account
for the purpose of demonstrating solvency
5. Custodianship of assets
6. Restrictions on the maximum exposure to a single counterparty
A custodian holds investments on behalf of an investor, and can often exercise voting rights
Ensuring investment is proper Income collection
Investment is offered by an authorized Tax recovery
institution Securities settlement
Provides custody of documents Foreign exchange
Risks involved in deciding investment strategy
Market risk
o Asset
o Liability
o Mismatch
Marketability risk
Liquidity risk
Interest rate risk
Reinvestment risk
Credit risk
Regulatory changes in investment type
Change in asset-wise investment percentages
Current holding position changes
Effect of change on overall returns
Mismatching of A/L (especially for long tail businesses)
Forced sale of certain investments (leading to losses / gains based on market conditions)
Tax impact
Change in reserves
Solvency requirement changes
Credit risk changes
Mitigation
Investments duration matched with liabilities
Liquidity: Securitization
Hedge against falling interest rates
Reinsurance
Reduce credit risk by investing in sovereign bonds
Invest in overseas bonds (but it has exchange risk)
