Investment section

Fisrt aim: meet liabilities.
Secondary aims:

• Return
• Solvency
• Uncertainty
• Liquidity
• Compliance

The main investment objective of an institutional investor is to meet the promised liabilities as they fall due.
Thus, an institutional investor should aim to hold assets that match the liabilities faced with regard to nature (i.e. fixed‐monetary or real), term and currency
However, there are also a number of secondary considerations including:

• maximising the investment return achieved
  • for an insurance company, this will lead to higher profits for shareholders or may allow lower premiums to be charged
  • for a defined benefit pension scheme, this will reduce the total cost of the promised benefits on the employer
• ensuring that ongoing requirements to demonstrate solvency can be met consistently
• level of uncertainty of existing liabilities (in both amount and/or timing)
• higher uncertainty will usually require a greater holding of liquid assets (such as cash) to meet unexpected liability outgo
• statutory, legal or voluntary restrictions on how the fund can be invested

The company will wish to invest in assets that match the nature, term and currency of the liabilities.
minimises the risk of insolvency as a result of adverse investment experience … since a change in the value of the liabilities (e.g. due to a rise in salary inflation or a fall in interest rates) should be reflected by a corresponding change in the value of the assets held to meet these liabilities.
Alternatively, a financial institution may choose not to match the assets and liabilities. The aim here would be to increase the investment return achieved by holding a mismatched position. A higher investment return would then lead to greater profits … which could be used to pay higher dividends to shareholders, to pay higher bonuses to with-profits policyholders or to reduce future contributions to a pension scheme for the sponsor and/or scheme members. However, in this case, it is crucial that the financial institution holds additional capital (known as free assets) to provide a cushion against adverse market movements (that will not necessarily be matched by a corresponding change in the value of the liabilities faced).

• Discuss the nature of assets and liabilities.
• Salary growth will often exceed price inflation.
• For fixed liabilities , immunisation could be used to minimise the investment risk faced, but this is subject to theoretical and practical problems

Benefit payments can be divided into four types:

• guaranteed in monetary terms
• guaranteed in terms of an index of prices or earnings
• discretionary
• investment-linked

• in practice, it may be difficult to find assets that match the duration of the liability outgo.
• Timing of outgos is uncertain (so liquidity of assets also important).
• If the liabilities are of short term, it would also be appropriate to hold a small proportion of the assets in cash (or shorter-dated bonds) to match the liabilities arising. Liquidity requirement
• For annuity, term is equal to expectation of life (so match with assets of similar term).

level of uncertainty of existing liabilities (in both amount and/or timing)

• how will this affect the investment strategy? greater uncertainty in liability outgo is likely to require investment in more liquid assets (e.g. cash) to meet unexpected short-term payments.

hen matching the asset and liability cash flows, an appropriate allowance for future mortality should be made to determine the expected liability outgo in each future time period

Total return on an asset comes from both income and capital gain. An investor’s preference for income or capital gain from investments is determined by two main factors:

• taxation
  • capital gain is often taxed at a lower rate than income … thus, many investors will prefer assets that provide a higher proportion of the total return as capital gain
  • why does an equity usually provide a higher proportion of the total return in the form of capital gain than a fixed-interest government bond?
    because future income can be expected to rise, leading to an expectation that future capital values will also rise
• cash flow requirements
  • investors with low current cash outflows will prefer low income yielding assets (as this avoids the expense and uncertainty of reinvesting excess income)

• reinvestment risk, as future premiums invested on unknown terms (Define the reinvestment risk!)
• (The implicit assumption is that future cash inflows (i.e. premiums or contributions) will be invested in due course to meet the liabilities accruing in future.)

An investor may make a short-term tactical decision to depart from the “normal” investment strategy in order to take advantage of temporary under-pricing (or over-pricing) of particular assets. The main factors to be considered before such a switch are:

• expected extra return relative to additional risk faced
  • after the switch, assets and liabilities are unlikely to be matched … increasing investment risk. also, risk that expected price changes do not materialise.
• the expenses of the switch
• the problems of switching a large portfolio of assets
  • may adversely affect prices
  • may take time to sell large quantity of a single asset
  • may crystallize capital gains (increasing tax payable)
  • these problems may be reduced by the use of derivatives (discussed more in Subject SP5)

Yields on FIBs will fall (and prices rise) if investors’ expectations of future inflation fall or if the size of the inflation risk premium falls. Either of these could occur with minimal impact on real yields (and, thus, on prices of ILBs). Thus, an investor whose expectations of future inflation are lower than the market expectations (as given by the difference between real yields and nominal yields) will find FIBs more attractive than ILBs (as, if correct, yields on FIBs should fall after purchase).
Why might expectations of future inflation fall?
(real) short-term interest rates are expected to rise (e.g. perhaps due to a change in government and/or government policy) . Why might the size of the inflation risk premium fall?
IRP is compensation for uncertainty regarding future inflation … so, a fall in IRP implies that future inflation is less uncertain without necessarily being higher or lower … however, usually, less uncertainty would be accompanied by a fall in general inflation levels. Conversely, the price of ILBs will rise (and real yields fall) as markets become more uncertain about the prospects for future inflation. Greater uncertainty about future inflation will lead to an increase in demand for securities that protect investors against unexpected inflation. ILBs protect policyholders from unexpected inflation.
The main economic circumstances that tend to cause greater uncertainty over expected future inflation are:

• less government commitment to a low inflation environment
• loose monetary policy
• devaluation of domestic currency
• rapid economic growth

Real investment return is not secured in nominal terms, if there are falls in the price index
Nominal investment is not secured in real terms

requirements

1. The present value of liabilities equals the present value of assets
2. The duration of liabilities equals the duration of the assets.
3. The convexity of the assets is higher than that of the liabilities

Limitations

• Applies to small changes in interest rates;
• Applies to uniform changes in interest rates;
• Immunised portfolio changes continuously;
• Immunises against profit (precludes policy switching). It removes the possibility of potential gain.
• It is often difficult to find bond portfolios to match very long duration liabilities.
• The theory is aimed at fixed money liabilities of fixed timing. It cannot be applied in any straightforward way to liabilities that are linked to salary / index.

Advantages of active management

• It is expected to obtain higher rate of returns through active management through buy under-priced assets and sell over-priced ones if the market is not efficient.
• If the negative portfolio management is applied, chosen index may perform badly.

Disadvantages

• Higher dealing cost due to frequent trades.
• The salary for the fund manager could be high.
• It brings in new risk: the fund manager could make false decisions. The fund may underperform the index.

Restrictions may include:

• the types of assets that must be held
• the types of assets that can be taken into account for the purposes of demonstrating solvency
• limits of self-investment
• limits on exposure to a single counterparty
• requirements to hold assets in the same currency as the liabilities
• limits on the extent to which mismatching is allowed ○ or, if so, a requirement to hold a specific mismatching reserve

• in relation to the liabilities
  • as this determines the scope for mismatching the assets with the liabilities in the hope of achieving a higher investment return
  • what are the main risks of mismatching the assets and liabilities by term?
• in absolute terms
  • a small fund is unlikely to be able to invest in large, indivisible assets (such as property), as it will not be possible to achieve a diversified portfolio
  • diversification helps reduce the volatility of the return on the portfolio (without reducing the expected return itself).

Diversification helps reduce the volatility of the return on the portfolio (without reducing the expected return itself).
Within a domestic equity portfolio, diversification can be achieved with regard to:

• industry grouping
  factors affecting one company within an industry are likely to be relevant to other companies in the same industry (e.g. cost of resources, changes in demand etc.)
• level of overseas exposure
  provides diversification against effect of currency movements
• by size of company
• by level of P/E ratio or dividend yield (i.e. income vs growth stocks)
  some stocks will perform better when the equity market is rising (i.e. cyclical stocks such as house builders), whilst others will perform (relatively) well when the equity market is falling (i.e. non‐cyclical stocks such as utilities)

An asset-liability model is a tool used to help determine what assets to invest in to meet a given objective.
Thus, in setting an investment strategy to control the risk of failing to meet the objectives, a method that takes into account the variation in the assets simultaneously with the variation in the liabilities is required.
This can be done by constructing an appropriate model to project both the asset proceeds and the liability outgo in each future time period. Then, the outcome of a particular investment strategy is determined and compared with the investment objectives … and, the strategy is then adjusted until an optimum strategy is found.

Liability hedging … or liability-driven investment (LDI) … involves choosing assets that perform in the same way as the liabilities.
In theory, this involves hedging against (or matching) all of the unpredictable changes in the value of the liabilities as a result of changes in unpredictable economic factors such as interest rates and price inflation.
In practice, full liability hedging will rarely be possible … except for unit-linked liabilities (where, by definition, the value of the liabilities is implied directly from the value of the underlying assets).
Thus, partial liability hedging will involve hedging with respect to specific factors that affect the value of the liabilities.