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Actuarial Risk Management (CA1) Notes

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Thema Modisi

on 15 April 2015

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Transcript of Actuarial Risk Management (CA1) Notes

Professionalism and the environment
What is subject CA1 all about
The actuarial control cycle-Fundamental tool for risk management
analysing situations, products and projects to understand risk exposure
quantifying consequences of risk events
determining appropriate approaches to risk management
monitoring situation and risk management procedures
Steps of the process:
The general economic and commercial environment
Specifying the problem -Primarily identifying risks
Developing the solution
Monitoring the experience
How to do a professional job
Jobs that actuaries do
Can be grouped into the areas of:
managing assets and liabilities
monitoring experience
Statutory Roles
In some territories there are roles that can only be taken by actuaries. These mainly relate to the certification of the adequacy of the valuation of assets and liabilities for a life insurer, general insurer or pension scheme, for example:
proper records have been kept for valuing liabilities
proper provision for the liabilities has been made
assets and liabilities have been valued according to legislative rules
liabilities have been valued in the context of the assets
the difference in the assets and liabilities has been stated
premiums or contributions are adequate to meet future commitments
professional guidance has been complied with
Actuaries may also work for the statutory body with personal responsibility for various areas of practice or are more commonly employed to check that regulatory objectives are adhered to
Professional framework of the Actuarial Profession
Requirements for professional conduct are set out in:
the Actuaries' Code
the Actuarial Profession Standards (AP Standards
and Guidance Notes.
These are issued by the Board for Actuarial Standards (BAS)
Doing a professional job
An actuary must:
act in a professional manner with integrity and detachment from their own personal circumstances
develop a direct, personal and trusting relationship with a client in order to advise on the most suitable solution for that particular client
recognise that others have valid views
attain and maintain competence in a given field
be reliable ie deliver good quality work in a given time frame
communicate clearly
recognise exactly who the client is and what their needs will be
recognise and seek to avoid conflicts of interest
Conflicts of Interest
Principles to adhere to when managing conflicts of interest include:
avoidance of the conflict
Chinese walls
- ring fence people and data
disclosure of the conflict to both parties
keeping detailed records of work assignments
notifying the regulators if the actuary believes that their client is not treating customers fairly
Carrying out an actuarial task
In carrying out an actuarial task to meet a clients needs, an actuary will:
ensure they are familiar with the context in which they are going to operate and the implications of the results
consider resources and time scales
define the task (with the client) and consider conflicts of interest
establish what are the questions that require answering
gather and assess the available information
set assumptions
decide on a method
arrive at "the solution"
check "the solution" (and get some one to check it)
communicate the answer in a way that is understood by the client
consider the professional implications of the work being done
There are many private sector stakeholders who actuaries can advise including:
insurance company - policyholders, prospective policy holders, board of directors, shareholders, creditors auditors
benefit schemes - members, their dependents, sponsors, trustees, auditors
investment fund mangers
member of investment schemes
sponsors of capital projects
Can also advise public sector such as:
government departments
related organisations eg regulatory bodies
Consideration of all stakeholders
Often advice given to a client by an actuary will impact on other stakeholders. The actuary needs to consider the interests of all stakeholders, and not only those who seek (and pay for) advice
Actuaries might advise:
policyholders on:
personal protection against death and illness
protection of property
members of benefit schemes and their dependents on provision of benefits on future events such as death, retirement, illness and withdrawal
employers on:
protection against financial loss arising from the death or ill health of employees
protection of tangible and intangible assets
provision of benefits that will attract and retain good quality staff
meeting legislative requirements
managing the costs of running their business
quantification of the amount of surplus capital in the business
investment of surplus capital
the board of directors of an insurance company on:
meeting legislative requirements
investing and managing the assets of the company
managing the liabilities of the company
determining the levels of provision to hold
setting premium rates
ensuring the policy proceeds are paid
meeting Policyholders Reasonable Expectations (PRE)
meeting shareholder demands
good corporate governance
obtaining appropriate/adequate reinsurance
shareholders of an insurance company on obtaining a good return commensurate with risk
creditors of an insurance company on the certainty that the monies owed to them will be paid back
trustees of benefit schemes on:
managing assets of the scheme
paying the benefits promised under the scheme as they fall due
maintaining solvency
sponsors of benefits schemes on:
providing protection and retirement benefits that meets the needs of members and their dependents
managing the cost of providing the benefits
meeting legislative requirements
employees on:
provision of protection benefits on death
provision of pension benefits on retirement
investment of surplus personal funds
auditors of insurance companies on:
the assessment of long-term liabilities for life insurers
the assessment of long-tail claims reserves for general insurers
auditors of the sponsors of benefit schemes on the assessment of the future liability to pay benefits
the Government on:
setting and monitoring adherence to legislation
funding and monitoring the funding of benefit provision by the state
regulator on ensuring the regulatory requirements are met
Information about the client
Before analysis of a problem, the actuary should ensure they are fully briefed on the client. Consider:
information in the public domain
a pre-project meeting with a client
attitude of a client, in particular risk appetite and culture
potential conflicts of interest
the circumstances and objectives
Results should be produced:
in a comprehensible format and timely way
taking into account the implications for all the stakeholders involved
Advice and decisions
There are different types of advice that can be given. These include:
indicative advice - an opinion
factual advice - based on researched facts
recommendations - involving research, modelling, consideration of alternatives
In giving advice actuaries should:
set out alternative solutions and the implications of each solution on both the client and other affected stake holders
outline the assumptions made and the reasons for making them
Ultimately the client decides which solution to adopt
The actuary needs to be aware of whether he/she is being asked solely to give advice or to make a business decision
External environment
Legislation and Regulations
require compulsory insurance in certain circumstances
influence the types of product available
regulate the sales process
State benefits
raise employers' awareness of the need to top up state benefits
raise the employees' awareness of the need to top up state benefits
introduce moral hazard of individuals relying on the State and not purchasing their own cover
reduce levels of saving if benefits are means-tested
if compulsory contributions are required, make individuals feel less wealthy and thus less able to purchase their own cover
affects the form of benefits within products
means that product innovations may be designed to avoid paying tax
directs savings towards most tax efficient forms i.e. income vs capital gains or tax shelters (ISA,401k)
Accounting standards
influence an employer's provision of employee benefits
influence the range of products offered
Capital adequacy and solvency
forms part of banking and insurance regulation
is carried out using a complex capital adequacy framework e.g. Basel II for banks
Corporate governance
encourages managers to act in the best interests of stakeholders
incentivises managers accordingly
should be monitored for effectiveness
may utilise non-executive directors
influences the way in which stakeholders' needs are met
Risk management requirements
are concerned with measuring, monitoring and controlling the impact of risks on a firm's balance sheet
can be categorised using the Basel II framework, categorises risk as:
market risk
credit risk
operational risk
Corporate structure
no shareholders
better benefits for the same cost (as propriety)
can't readily raise funds by usual methods
certain products may be restricted or more highly priced (especially those that are capital intensive)
product pricing either "at cost" or takes allowance for surplus distribution to with-profit policy holders
Propriety/Public companies:
easier access to capital markets for finance
economies of scale
more dynamic management
must deal with how to distribute surpluses between shareholders and with-profit policy holders
Private companies
may find the same difficulties as mutuals in raising capital
will benefit from a close involvement of the owners
Commercial consideration
Mainly the concept of the underwriting cycle. Position in the cycle is an important consideration when making strategic decisions
The underwriting cycle relates to:
profitable business leading to new entrants, greater competition, "soft" premium rates and reduced profits...leading to...
insurers leaving the market or reducing their involvement, increased premium rates or loss of business or reduced solvency and the need for capital
Changing social trends
Impact on financial products, schemes, contracts and transactions available
Demographic changes
can have a major impact on main benefit providers e.g. state
include increasing longevity and falling birth rates
may result in an ageing population which leads to:
less spending, as older people save more
a strain on social welfare systems
an increased cost of healthcare
the cost of education falling
Environmental issues
influence the ways in which the government, advocacy groups and individual participants act, and hence the behavior of the financial markets
has led to providers offering products that promote environmental and ethical issues
affects how providers communicate with customers e.g. reducing the amount of paper work
Lifestyle considerations
younger people have preferences for loans rather than savings
people with children look towards life insurance protection products
older people have a need for annuities and long term care products
International practice
leads to overseas products being replicated in the domestic market, subject to tax and legislative considerations
Technological changes
impact on the way in which financial products are provided e.g.:
credit card
telephone banking
Aims of regulation
The principal aims of regulation of financial services are to:
correct market inefficiencies and to promote efficient and orderly markets
protect consumers of financial markets
maintain confidence in the market
help reduce financial crime
As well as conferring benefits, financial services regulation will normally also confer costs, both direct and indirect, upon the various participants involved. Often, these will ultimately be borne by the investor in the form of increased charges.
Direct costs
administering the regulation
compliance for the regulated firms
Indirect costs
alteration in consumer behavior
undermining of a sense of professional responsibility amongst intermediaries and advisors
reduction in self-regulation by the market
reduced product innovation
reduced competition
Need for regulation
The need for regulation is greater in the financial world than in other markets in order to:
maintain confidence in the sector
deal with information asymmetries
Functions of the Regulator
The main functions of a regulator are typically:
influencing and reviewing Government policy
vetting and registration of firms and individuals authorised to conduct certain types of business
supervising the prudential management of financial organisations and the way in which they conduct their business
enforcing regulations, investigating suspected breaches and imposing sanctions
providing information to consumers and the public
Areas addressed by regulation: information asymmetries
Asymmetries occur when one party has relevant information or expertise or negotiating strength not shared by another party
They can lead to anti-selection and can be caused by moral hazard
The asymmetries are exacerbated by the complex and long term nature of financial contracts
Mitigation tools include:
disclosure of information in plain language
chinese walls
cooling off periods
customer legislation on unfair contract terms and TCF
"whistle blowing" by actuaries if believe the client is treating customers unfairly
Areas addressed by regulation: maintaining confidence
There is a danger that problems in one area of the financial system spread, leading to the collapse of the whole system
Mitigation tools include:
checks on capital adequacy of providers
ensuring practitioners are competent and act with integrity
industry compensation schemes
ensuring orderly and transparent markets
stock exchange requirements
Regulatory regimes
The main types of regulatory regime are:
unregulated markets - no financial services specific regulations apply, market participants are instead subject to the normal laws of the land
voluntary codes of conduct - drawn up by the financial services industry itself
self-regulation - organised and operated by the participants in a particular market without government intervention
statutory regulation - in which a government body sets out the rules and polices them
mixed - a combination of the above
Each of the above regimes can adopt any of the following forms:
prescriptive regimes - with detailed rules on what may or may not be done
freedom of action - with rules only on publicity of information
outcome based regimes - with prescribed tolerated outcomes
Introduction to financial products and customer needs
Benefits can be catergorised as:
benefits on events unpredictable in time
benefits on events predictable in time
benefits for immediate consumption
benefits from the accumulation of disposable income and capital
Financial products
The main type of financial products, schemes, contracts and transactions fall into the following categories:
insurance contracts
reinsurance contracts
pension schemes
investment schemes
Insurance contacts
In return for payment (single or series) the provider will pay an agreed amount to individual or dependants/heirs that start or end on a pre-specified event. The event may happen to the individual, individual's property or a third party.
Reinsurance contracts
Used by providers to pass on some of the risk they take on
Pension schemes
Invovles the accumulation of funds paid out on a later date e.g. retirement, death or withdrawal from the scheme
Products and contract design
Investment schemes
Investment schemes involve an individual paying a single payment or series of payments to a provider with the expectation that a higher amount will be paid back at a later date
A derivative is a financial instrument whose value depends on the value of other investments. Can be used by providers of financial products to pass on risks to third parties
Customer needs
It's important to differentiate between a customer's:
logical and emotional needs
current and future needs
A customer's logical needs are determined by analysis and prioritisation. They can be analysed as follows:
protection, eg against death, loss, illness, accident, theft
accumulation for a purpose e.g. income in retirement, repayment of a mortgage
accumulation for a purpose as yet unknown out of any remaining disposable income or capital
Emotional needs are not identified in such a methodical way but are the result of what a customer thinks is needed or wants

A current need is one triggered by an event that has an immediate effect on a customer's circumstances e.g. protection against sickness
A future need may be one that relates to a customer's future aspirations e.g. to retire at a certain age
Benefits overview and providers of benefits
Type of scheme
Defined Benefit:
benefits defined independently of contributions payable
benefits not directly related to scheme investments
scheme can be funded or unfunded
Defined contribution:
benefits depend on contributions paid with respect to that member
These are increased by investment returns earned
offers the better of defined benefit or defined contribution type benefit
or some defined benefit and some defined contribution sections
Benefit providers
Benefits can be provided by:
the State
financial institutions
other corporations
The major roles played by the State are:
direct provision of benefits e.g. retirement, death, ill health
regulation to encourage or compel benefit provision
regulation of benefit providers
The State can also provide financial instuments e.g.:
issue bills and bonds
savings plans
deposits with the State Bank
Have a variety of reasons to sponsor benefits:
compulsion or encouragement from the State
to meet business objectives e.g. attract and retain good staff
to pool expenses and expertise
Benefits can can be provided through a formal employer-sponsored scheme. This can ensure a consistent approach across employees or help the employer target certain groups
Organisations can tailor benefits offered through a flexible benefits system. Employees can trade in some of their existing benefits for other financially equivalent benefits
This enables employees to select benefits that are appropriate to their circumstances. May change over time. Employers use flexible benefit systems to attract, motivate and retain staff
Employer sponsored schemes can be sponsored jointly by many employers e.g. industry-wide schemes
Apart from being beneficiaries, individuals also finance benefit provision. The motive for this can be:
compulsion or encouragement by the State or employers
the individuals personal preference
Provisions can be formally structured savings plans, generated by the State, employers or other financial organisations. Alternatively, individuals can make informal unstructured arrangements
Pooling of resources by individuals for mutual benefit is also seen e.g. Continuing Care Retirement Communities
Individuals may use domestic property as an investment through equity release schemes or may benefit from property through inheriting it
Financial institution and other corporations
Vehicle for providing benefits is often provided by financial institutions either via employer- run schemes or directly to individuals
Institutions are also pro-active in highlighting the need to individuals to make provision
Life insurance overview and life products
Pure endowment and endowment assurance
Pure endowment - provides a benefit on survival to a known date. Acts as a savings vehicle e.g. provides a benefit on retirement or means of repaying a loan

Endowment assurance - provides a significant benefit on the death of the life insured before that date and therefore operates also as a vehicle for providing protection for dependants
Whole life assurance
Provides a benefit on the death of the life insured whenever that might occur
Term assurance
Provides a benefit on the death of the life insured provided it occurred within the term of the contract. Do not usually have any benefits paid on withdrawal
Convertible or renewable term assurance
Allow conversion to permanent contract (e.g endowment or whole life) or renew the contract for a further term without further evidence of health being required
Immediate annuity
A single premium purchasing an income stream, which commences immediately after purchase
Long-term care
Provides a cash sum on the diagnosis of a specified illness in the policy documents
Critical illness
Time between date of purchase and date when income is required to start (vesting date). Contract can be paid either by single premium or by regular premiums during the deferred period
Deferred annuity
Used to provide financial security against the risk of needing either home or nursing home care as an elderly person ie post retirement
Income protection
The contract enables individuals to provide an income for themselves and their dependants during periods of long term sickness or incapacity due to accident or illness. Usually terminate at retirement age
Investment types
The main life insurance policy investment types are:
without-profit (benefit amount or method of calculation specified)
with-profit (benefit involves a share in the surplus of the company)
unit-linked (benefits depend on the value of a unit fund)
index-linked (benefit moves in line with a specified investment or economic index)
General Insurance overview and general insurance products
Liability Insurance
Provides indemnity where the insured due to some form of negligence, is legally liable to pay compensation to a third party

Cover is on an indemnity basis but an excess may be payable and/or a maximum level of cover may apply

Main types of liability insurance:
employers liability - perils include accidents in the workplace due to negligence of an employer or employee, exposure to harmful substances/working conditions
motor third party liability - perils include motor accidents caused by the insured
public liability - perils depend on the type of policy e.g dog bites, falling objects
product liability - perils include faulty design, manufacture, packaging, misleading instructions
professional indemnity - perils depend on the profession of insured e.g. wrong diagnosis, error in actuarial report
Property damage insurance
Indemnifies insured against loss or damage to their own material property

Cover is on an indemnity basis but an excess may be payable and/or a maximum level of cover may apply. Household contents insurance is usually written on a new for old basis

Main types of property damage insurance:
residential and commercial building - perils include fire, explosion, lightning, theft, storm, flood
moveable property - major peril is theft other perils as per buildings insurance
land vehicles - perils include accidental damage, theft
marine craft - perils include perils of the sea, fire, jettison, explosion, piracy
aircraft - similar perils to marine craft but air based
Fixed benefits insurance
Does not operate on an indemnity basis

Main types of fixed benefit insurance:
personal accident - perils include loss of limb or other specified injury from an accident
health - perils include the need for treatment in a hospital
unemployment - the peril is redundancy
Financial loss insurance
Provides indemnity against financial losses arising from a peril covered by the policy

Cover is on an indemnity basis but an excess may be payable and/or a maximum level of cover may apply

Main types of financial loss insurance are:
pecuniary loss (loss due to failure to pay by a third party) - perils include bad debts or failures of third parties, includes mortgage indemnity guarantee insurance
fidelity guarantee - perils include dishonest actions by employees e.g. fraud and embezzlement
business interruption a.k.a. consequential loss - perils include fire in the insured's property or neighbouring property
Cashflows of simple products
Cashflows are simply sums of money that are paid or received at particular times

A cashflow projection sets out expected payments and receipts under a contract

Providers of financial products will usually aim to match expected payments and receipts. Not trivial because timing and amounts of payments and receipts maybe uncertain

Where there is uncertainty probabilities can be assigned to both the amount and existence of a cash flow

Instead of matching liabilities providers can also hold additional capital to cover the risk that assets are insufficient to cover cashflows
Cashflow matching and process
Contract Design
Contract design factors
In designing and reviewing any contract the following factors need to be considered:
customer needs and interests
characteristics of other stakeholders involved in contract design
risk appetite of the parties involved
the level and form of benefits
options and guarantees
discretionary benefits
discontinuance benefits
contract terms and conditions
statutory/regulatory requirements
financing requirements
premium/contribution patterns
charges vs expenses
extent of cross subsidies
consistency with other contracts
administration systems
accounting implications
These factors are neither independent nor mutually exclusive. Sometimes they will be conflicting and difficult to resolve
Project management
The key factors in managing a successful project include:
a clear definition of the aim of the project reflecting customer needs
full planning
thorough risk analysis
regular monitoring of developments
measurement of performance and quality standards
thorough testing at all stages
management of critical path issues
appropriate pacing so that the right things are done at the right time
stable but challenging relationships with external suppliers
a supportive environment
excellent communications between those involved
positive conflict management
a schedule of what needs to be considered at each milestone review point
A good project management team will always keep clear documentation and audits of changes. A key document is called the written strategy. This document contains details of the:
objectives of the report
financial and economic objectives
statements of how these objectives will be met
breakdown of the work to be completed
key milestones for project review
quality standards for meeting the objectives
project sponsor's role
role of any third parties eg consultants employed
expected cost of the project
need for insurance or reinsurance
financing policy
legal policy
technical policy
risk management policy
communications policy
IT policy
conflicts of interest policy
The project team
Project owner or Project sponsor - Ultimate owner of the project. Responsible for scheduling
Project manager - in charge of the design and build of the project. Should be able to establish direction, decide on action, organise resources and motivate the project team
Project team - should be competent and committed to the success of the project. End users of a project should be involved. good communication between the parties of a project is vital, particularly between:
designers and builders
specifiers and implementers
project owners and project managers
Capital project appraisal
Capital project - Any project where there is an initial expenditure then stream of revenues less running costs. Doesn't have to involve the construction of a physical asset
The initial appraisal
Main purpose - ascertain whether project satisfies the criteria established by the sponsoring organisation for projects it is prepared to authorise. The criteria is usually expressed in terms of:
financial results and risks
synergies with other projects
political constraints
sufficient upside potential
use of scarce resources
If criteria is satisfied, project is accepted and moves into detailed appraisal process
Evaluating cashflows
Financial criteria maybe expressed in terms of:
payback period
discounted payback period
A distribution of NPVs can be created by:
creating a number of deterministic scenarios
stochastic modelling
This stage of the project will be iterative with the risk identification, analysis and mitigation stages
A suitable risk discount rate must be chosen to calculate the NPV of the project
Setting the risk discount rate
If the project is considered to have a normal amount of systemic risk:
Start by looking at the current cost of raising incremental capital for the company to carry out the project
Should be company's normal cost of raising capital, taking this as a weighted average where weights are based on the optimum capital structure
The cost of debt capital should be taken as the net cost in real terms of new borrowing by the company
The cost of equity capital is the current expected total real return on index linked bonds plus a suitable margin to allow for the additional return that equity investors seek to compensate them for risk
This gives a real discount rate, to be applied to cashflows expressed in present day monetary values, or adjusted by an assumed inflation rate and used with nominal cashflows
If the project is considered to have a higher than normal degree of systematic risk then the risk discount rate is typically based on risk discount rates used by similar companies that conduct similar projects. Where such info is not available the risk discount rate may be set by applying an arbitrary addition to the optimum WACC above
Specific risk or probabilistic risk - element of risk than can be eliminated either by repeated investment in the same project or by diversification over a number of different projects
Specific risk should be allowed for in the cashflows i.e. probability of occurrence or the size of the cashflow
Specific risk analysis consist of identifying and quantifying the risks and managing any residual risks that remain
Specific risks must be:
Specific risks that cannot be mitigated are known as residual risks and must be managed carefully and highlighted to the sponsors
Specific risks can be identified using :
a high level preliminary analysis
brainstorming with experts
a desktop analysis
a risk register
a risk matrix
The analysis of specific risks involves characterising them by:
frequency of occurrence
the financial consequence
correlations between risks
their controllability
Six key methods of mitigating specific risk include:
avoiding the risk
reducing the risk (frequency/ consequences)
insuring the risk
sharing the risk
transferring the risk
further researching of the risk
Each mitigation option for a particular risk will be evaluated assessing:
likely effect on frequency, consequence and expected value
feasibility and cost of implementing the option
any "secondary risks" resulting from the option
further mitigating actions to respond to secondary risks
overall impact on the distribution of NPVs
Systematic risk - element of risk that cannot be eliminated by diversification, no matter how widely we spread our investment and no matter how often a particular project is repeated. A.k.a systemic or non-diversifiable risk or market risk
Systemic risk is usually reflected in the choice of risk discount rate used to calculate the net present value of the project
Investment decision
Final investment decision will reflect:
distribution of NPVs
characteristics of residual risks that cannot be mitigated
Particular attention to the expected NPV and the possible impact of those remaining risks that could have a major negative impact upon the financial outcome of the project
The results of the detailed appraisal will be written up in document called the investment submission
Considerations in the investment decision, beyond the investment submission, might include:
allowance for any likely bias or possible approximations in the estimates
knowledge not in the possession of those who have prepared the submission
last minute developments
doubts about feasibility or quality of implementation
overall project credibility
Financial securities
Money market
Type of money market instruments
Money market instruments can be issued by:
the Government (treasury bills)
regional government bodies (local authority bills)
companies (bills of exchange, commercial paper)
banks (different types of deposit)
Bank deposits include:
call deposits - instant access to withdraw funds
notice deposits - give period of notice before withdrawal
term deposits - no access to capital sum earlier than maturity of the deposit
certificates of deposits - tradable notes that state how much has been deposited
Interest rates on bank deposits may be fixed or variable over the term of investment
Investment and risk characteristics of money market instruments
normally good security as term is very short
all return is through income (or capital gains that is usually considered income)
level of income has loose indirect link with inflation
lower expected returns than equities or bonds over the long term
stable market values
low dealing expenses
normally highly marketable
return normally taxed as income
Main players
Main players are:
clearing banks - use money market instruments to lend excess liquid funds and to borrow when they need short-term funds
central banks - act a lenders of last resort, stand ready to provide liquidity to the banking system when required, buys and sells bills to establish the level of short-term interest rates
other financial institutions and non-financial companies, who lend and borrow short-term funds
Reasons for holding money market instruments
Institutions may hold a portion of their funds in money market investments for the following reasons:
to meet short-term commitments
to be ready to take advantage of other investment opportunities
because outgo is uncertain
because the institution has received funds which are awaiting investment in some other asset category
because the institution needs to protect the monetary value of assets
Institutions may also hold money market instruments temporarily if they are pessimistic about the out look for other assets, eg if they expect:
rising interest rates ( which might cause other assets to fall)
economic recession (with a fear that equity and possibly bond prices will fall)
the domestic currency to weaken (which makes overseas cash holdings attractive)
general economic uncertainty
Bond Markets
Bonds - fixed interest or index linked securities traded on a bond market
Fixed-interest or conventional bond gives an income stream and final redemption proceeds that are fixed in monetary terms
Index-linked bond gives an income stream and final redemption proceeds that are linked to an inflation index
Bond markets
The most important distinct types of bond market are:
the markets in government bonds listed in their country of origin
the markets in corporate bonds listed in their country of origin
the markets in overseas government and corporate bonds listed outside their home country
Investment and risk characteristics of conventional government bonds
very good security (in politically stable countries)
yield (gross redemption yield) is fixed in nominal terms
lower expected returns than equities in the long term
market values can be volatile especially for longer-term bonds
low dealing expenses
highly marketable
Corporate bonds
Main types of corporate bonds:
Debentures (fixed charge - mortgage debentures)
unsecured loan stock
subordinated debt
Corporate bonds are generally less secure and less marketable than government bonds -so, investors will generally require and higher yield in order to hold them
Yield curve theories
Yield curve - plot of gross redemption yields against term to redemption
Theories to explain the shape of the yield curve:
Expectations theory - yields reflect future short term interest rates and inflation
Liquidity preference theory - investors require additional yield on less liquid (longer-term) bonds
Inflation risk premium theory - investors require an additional yield on longer term conventional bonds to compensate for the risk of inflation being higher than anticipated
Market segmentation theory - yields at each term are determined by supply and demand at that term. Demand comes principally from institutional investors trying to match liabilities
The real yield curve - plots real gross redemption yields on index linked bonds against term to maturity. Difference between real yield curve and conventional yield curve is approximately the market's expectations of future inflation
Relative attractiveness of conventional and index-linked bonds
An investor whose expectation for future inflation is lower than that implied by the difference between nominal and real yields in the market will find conventional bonds more attractive than index-linked bonds and vice versa.
Equity Markets
Equity markets
An ordinary share is a share in the ownership of a company
Investment and risk characteristics of equities
security depends on the profitability of the company
provides a long-term real yield
higher expected returns than government bonds over the long term
income (dividends) and capital values (prices) can be volatile
equities can generally be held in perpetuity
dealing expenses are linked to marketability
marketability depends on the size of the company
Quoted shares
Quoted shares are listed on a stock exchange and make up the majority of available equity investment. Quoted shares are generally:
more marketable
more secure
easier to value
than non-quoted shares
Industry groupings
Shares are grouped by industry sectors because:
it is practical for analysts to specialise in one area
the share prices of companies in the same sector tend to be correlated
It is practical for analysts to specialise in one area because:
factors affecting one company in an industry are likely to affect other companies in the same industry
company information in a particular industry is likely to come from a common source and be presented in a similar way
no one analyst can expect to be an expert in all areas, so specialisation is appropriate
the grouping of equities according to some common factor gives structure to the decision making process. Assisting portfolio classification and management
Share prices of companies in the same sector are correlated because:
they use the same resources and so have similar input costs
they supply to the same markets and are similarly affected b changes in demand
have similar financial structures and so are similarly affected by changes in interest rates
Preference shares
A particular type of share that:
generally ranks ahead of ordinary shares
normally pays a specific rate of dividend
does not entitle shareholders to residual profits
usually does not come with voting rights
Part of a companies share capital but from a investment perspective is much more like a fixed interest bond
Property Markets
Prime property
Prime property scores highly on all of the following factors:
age and condition
quality of tenant
number of comparable properties
lease structure
Investment and risk characteristics of property
void and default risk
obsolescence, deterioration and refurbishment costs
susceptible to political risk
long-term real returns
expected return higher than that on index-linked government bonds
stepped up income stream
running yield varies with the type of property
can provide high utility (feel good factor) to the investor
long-term volatility of capital values but short term stability due to infrequent valuations
high dealing and management costs
possibility for investment characteristics to be changed by the investor eg redevelopment
large unit size
subjective valuations
Freehold and leasehold
absolute property owner in perpetuity
can let the property to a leaseholder in return for annual ground rent
Shorter term than freehold investment
provides a higher rental yield than freehold investment
Will result in a capital loss if lease is held to termination date
Indirect property investments
Key issues to consider when comparing direct and indirect property investments include:
correlation with equities
discount to NAV
exposure to other sectors
forced sales
May be available as pooled property funds and property share companies
Futures and options
Derivative - financial instrument with a value dependent on the value of some underlying asset
gives investor the right but not the obligation to buy or sell a specified asset on a specified future date
Call options give the right to buy
put options give the right to sell
American option can be exercised at any date before its expiry
European Option is an option that can only be exercised at expiry
Futures contract - standardised, exchange-tradable contract between two parties to trade a specific asset on a set date in the future at a specified price
Forward contract - non-standardised, over the counter contract between two parties to trade a specific asset on a set date in the future at a specified price
Warrant - option issued by a company. Gives holder right to purchase shares at a specified price at specified times in the future
Long position - long party takes delivery of the asset in the future
Short position - short party must deliver the asset in the future
Collective investment schemes (CISs)
Collective investment schemes (CISs)
CISs - provide opportunity for investors to achieve a wide spread of investments, whilst benefiting from specialist management expertise
Closed ended CIS- eg Investment Trust Company (ITC) - once initial tranche of money has been invested the fund is closed to new money
Open-ended CIS - example unit trust (UT) - managers create or cancel units in the fund as money is invested or disinvested
Regulation of CISs usually covers aspects such as:
the categories of assets that can be held
whether unquoted assets can be held
the maximum level of gearing
any tax relief available
Investment trust companies (ITCs)
Key features of ITCs include:
a stated investment objective
key parties - board of directors, investment managers and shareholders
shares are priced by supply and demand
share price often stands at a discount to net asset value (NAV) although can stand at a premium
funds are closed-ended
they are public companies governed by company law
gearing is allowed
Unit trusts (UTs)
Differences UTs vs ITCs
Shares in ITCs are often less marketable than the underlying assets. Marketability of units in UTs is guaranteed by the manages
Some UTs eg property need to hold cash to maintain liquidity. This implies lower expected returns but greater price stability
ITCs can gear, leading to greater volatility. UTs have limited power to gear
Increased volatility of ITCs implies higher expected returns
ITC more volatile than the underlying assets because the size of any discount to NAV changes. The volatility units in a UT should be similar to underlying assets
There maybe uncertainty as to the true level of NAV per share of an ITC, especially if investments are unquoted
ITCs can invest in a wider range of assets than UTs
It maybe possible to buy assets at less than NAV in an ITC
They may be subject to different tax treatments
Advantages of indirect investment vs direct investment
Access to larger/more unusual investments
Discount to NAV - assets may be bought cheaply (ITCs)
Economies of scale in the case of larger collective schemes
Expected return higher due to extra volatility associated with gearing and the discount to NAV (ITCs only)
Expenses associated with direct investment avoided
Expertise of investment managers
index-tracking of a quoted investment index is possible
marketability may be better than that of the underlying securities (although the opposite may be true)
Quoted prices, make valuation easier
Tax advantages possible
Key features of UTs include:
a stated investment objective
key parties - trustees, investment managers and unitholders
investors buy units in a UT, which are priced at NAV
funds are open-ended
they are trusts, governed by trust law
generally no gearing is allowed
Disadvantages of CIS vs direct investment
Lack of diversification away from equities
loss of control
management charges incurred
Extra volatility caused by gearing and or discount to NAV (ITCs only)
Tax disadvantages possible
Overseas markets
Why Invest overseas?
Three main reasons for investors to hold foreign assets:
1) to match liabilities in the foreign currency
2) to increase expected returns due to
strengthening currencies
higher risk or fast-growing economies
undervalued markets
3) to reduce risk by increasing the level of diversification
Overseas investment has some potential drawbacks:
liabilities maybe mismatched by currency
currency movements cause additional volatility
possible tax disadvantages, e.g. withholding tax
cost of obtaining expertise
cost of/need to appoint an overseas custodian
additional administration
problems repatriating funds
different accounting methods/standards
lack of good quality information
language problems
possible time delays
poorly regulated markets and political instability
political risks (eg confiscation of assets)
possible lack of liquidity and marketability
restrictions on ownership of certain shares by foreign investors
What to invest in overseas
Most main asset categories available overseas. Indirect investment can be useful especially for small investors looking for exposure to specialist niche markets
Indirect overseas investment may involve investment in:
multinational companies based in the home market
domestic companies with a substantial export trade
collective investment schemes specialising in overseas investment
derivatives based on overseas assets
Emerging markets
Factors to consider before investment in emerging markets include:
current market valuation
possibility of high economic growth rate
currency stability and strength
level of marketability
degree of political stability
market regulation
restrictions on foreign investment
range of companies available
communication problems
availability and quality of information
withholding taxes that apply
expertise in the markets
extra costs, eg custody fees
extent of additional diversity generated
Emerging markets can be very volatile, this gives investors the chance of making very big gains (or very big losses). Such markets can be affected by enormous flows of money generated by changes in investor sentiment
The economies of many smaller countries are less interdependent than those of the major economic powers, resulting in good diversification
Valuing assets
Other influences on investment markets
Demand factors
An Increase/decrease in the demand for an asset will lead to an upward/downward pressure on the price of the asset
Demand for an asset will change if either:
investor's perceptions of the characteristics of the asset, principally risk and expected return alter
investor opinions of the properties of the asset remain unchanged but external factors alter the demand for that asset. These include:
investors' incomes
investors' preferences
the price of other assets which may be substitute goods
Investors' preferences are influenced by:
a change in their liabilities
a change in the regulatory or tax regime
uncertainty in the political climate
fashion or sentiment altering, sometimes for no discernible reason
investor education undertaken by the suppliers of a particular asset class
Supply factors
An increase/decrease in the supply for an asset will lead to and downward/upward pressure on the price of the asset. Supply increased by new issues and decreased by redemptions
Economic influences on investment markets
Interest rates
Short-term interest rates are determined by government policy, as the government balances:
the need to control inflation
the need to encourage economic growth
management of the level of the exchange rate
Bond yields
Main factors affecting bond yields are:
short-term interest rates
the fiscal deficit
the exchange rate
institutional cash flow
returns on alternative investments, domestic and overseas
The level of the equity market
The main influences on the above are:
expectations of real interest rates and inflation
investors' perceptions of the riskiness of equity investment
the real level of economic growth in the economy
expectations of currency movements
Other factors influencing the level of the equity market include:
supply factors
the political climate
overseas equity markets
institutional cashflow
alternative investments
The level of the property market
Economic factors can affect:
the occupation market
development cycles
the investment market
Economic factors that have a big impact on the property market. The key factors are:
economic growth
real interest rates
Inflation, institutional cashflow and exchange rates are relevant to a lesser degree
The inelastic supply of property magnifies the impact of the factors on overall property values. The inelastic supply of property is caused by:
the time required to develop new properties
planning permission rules and limited physical space in some areas
fixity of location
high transaction costs
segmented markets
Relationship between returns on asset classes
Returns that investors, as a whole, require can be written as:
where capital growth occurs either due to:
income growth
a change in the initial income yield
Over the long term, equity dividend growth might be expected to be close to growth in GDP, assuming that the share of GDP taken by "capital" remains constant
The real return on index linked bonds is known at outset, if they are held to redemption. This real yield is often taken as the benchmark required real yield for the analysis of expected returns on equities
Returns on cash might be expected to exceed inflation except in periods where inflation is rising rapidly and is under-estimated by investors
A reasonable assumption over the long term would be that wages and salaries would grow in line with GDP
Valuation of asset classes and portfolios
Expected return on different asset classes
Government bonds : Gross Redemption Yield (GRY)
Corporate bonds: GRY
Equities: dividend yield + expected dividend growth
Property: rental yield + expected rental growth
Required return on different asset classes
Government bonds: risk-free real yield + expected inflation + inflation risk premium
Corporate bonds: risk-free real yield + expected inflation + bond risk premium
Equities: risk-free real yield + expected inflation + equity risk premium
Property: risk-free real yield + expected inflation + property risk premium
Equating expected an required returns
If assets are fairly priced, then expected and required returns can be equated
Yield gap - dividend yield on equities less the gross redemption yield on long dated government bonds
Other ways of assessing cheapness/dearness of asset classes
To justify government bond yields being above equity dividend yields then one of the following must hold:
high uncertainty over future inflation
low equity risk premium
high prospects of real dividend growth
high expected inflation
Reverse yield gap:
GRY-d = inflation risk premium -equity risk premium + real dividend growth +expected inflation
Valuation of individual investments
Valuation methods for individual investments
There are many different ways in which assets can be valued. The correct method will depend on the purpose of the valuation and on the type of asset being valued. Common methods of valuing assets include:
(historical) book value
written up or written down book value
market value
smoothed market value
fair value
discounted cashflow
stochastic modelling
arbitrage value
Market values vs calculated values
Market values:
generally easily available
well understood
they can be volatile
can be difficult to value liabilities in a consistent, market-based manner
Bond valuation
Equity valuation
The discounted dividend derives the value of a share as the discounted value of the estimated future dividend stream.
The definitions and assumptions underlying this discounted dividend model are:
D is the prospective dividend, paid annually, starting in one year
i is the required constant annual rate of return from the share(s)
g is the assumed constant rate of growth each year in dividend payments ad infinitum
taxes and expenses are ignored
Bonds are valued by calculating the discounted value of the constituent cashflows. The discount factor used to value each payment should be based on the market spot interest rates of the appropriate term, adjusted to reflect the riskiness of the payment and the marketability of the particular bond
Property valuation
Property can be valued using an explicit discounted cashflow approach. The cashflows valued should be net of all outgoings and should make explicit allowances for the expected rate of increase of rental income
The level of interest rates is usually a little above the rate of inflation
The general level of the equity market is determined by investors' expectations of future corporate profitability and the value of those profits
Supply of government bonds is influenced by the fiscal deficit and the government's strategy for financing the deficit
Supply may also be increased by technological innovation. This is particularly true of derivative markets
Required return = required risk-free real rate of return + expected inflation + risk premium
Expected return can be analysed as:
Expected return = initial income yield + expected capital growth
If assets are fairly priced, required and expected return will be equal. More generally, by comparing the estimates of the two figures, an investor can determine whether or not an investment or asset class appears to be good value
For fixed-interest stocks there is no income growth. The initial yield and the capital value change for a bond held to redemption combine to give a fixed nominal total return, called the gross redemption yield
Using a value other than the market value implies taking a view as to where the market is going. Under such circumstances the actuary must ensure the client understands the implications, especially with respect to short term solvency
The general discounted dividend model is given by:
D(t) is is the gross amount the t dividend payment
v(t) is the discount factor applied between time 0 and the time of the t dividend payment
The simplified dividend model is given by:
The valuation formula can be modified for any changes in the assumptions
Other equity valuation methods include:
net asset value
value added methods, such as economic value added (EVA)
measurable key factors of a company's business
Options and futures
Options and futures are usually valued using techniques based upon the principle of no arbritage, whereas swaps can be valued by discounting the component cashflows
The discount rate used should depend on the riskiness of the investment and could be based on the yield on a bond of suitable term, plus margins for risk and lack of marketability
Wherever a security provides a choice between alternative courses of action the value of the security to the party that has the choice will include an element of time and or option value
Swaps can be valued by discounting the two component cashflows. At inception the value (at market rates of interest) of a swap to both parties will be zero, ignoring the market maker's profit and expenses
As market interest rates change ( or exchange rates, in the case of currency swaps) the value of the two cashflows will alter, leading to a positive net value for one party and a negative net value to the other
Risk premiums
The corporate bond risk premium is needed to compensate the investor for:
inflation risk
possible default
The equity risk premium is needed to compensate the investor for:
possible default
volatility of share prices and dividend income
The property risk premium is needed to compensate the investor for:
possible default and risk of voids
large unit size and indivisibility
risk of depreciation and obsolescence
high dealing and management expenses
Comparing yields on asset classes
Reverse yield gap - GRY less dividend yield. If the expected and required yields on equities and bonds are equated then:
If these conditions do not hold and government bond yields being above equity (dividend) yields, government bonds appear cheap relative to equities
For the assessment of property investment we use rental yields
When assessing overseas assets, we also need to allow for expected levels of currency appreciation/depreciation
An overseas market would be considered cheap if:
expected return in local currency + expected depreciation of home currency > expected return in home currency
There are a number of other tests of the relative value that investment analysts use from time to time. These include:
yield norms
index levels and price charts
yield ratios
Choosing a valuation method for the assets and liabilities
Method and basis of actuarial valuation will depend on:
purpose of valuation
type of liability
in some cases it is prescribed by legislation
It is important that assets and liabilities are valued consistently
Most widely used methods for actuarial purposes are market value and discounted cash flow
Market values can be used for most asset types. However, market values can be volatile and it may be more difficult to carry out a consistent valuation of liabilities
If a market value approach is used for the assets, then the liabilities must be valued using a market-based discount rate, which can be difficult to determine
Discounted cashflow methods can more easily be made stable and consistent with the valuation of liabilities (which is typically done using a discounted cashflow approach). Assumptions regarding future interest rates, inflation and economic growth can be made consistent for the valuation of both assets and liabilities. However, such an approach may be viewed as subjective and is difficult to explain
Allowing for the volatility of asset values
There are two main sources of the variability of asset values:
short term market movements
a change in the asset mix
Volatility in the asset prices is not a problem in itself and may correctly reflect the underlying reality. However, in the context of the on-going valuation of a long-term fund, comparing volatile asset values with the value of liabilities calculated using a stable interest rate is potentially misleading. The real problem in not volatility but the inconstancy of asset and liability valuation bases
Investment Strategy
Investment strategy - individuals
Investment strategy for individuals
The main factors an individual should consider in making investment decisions are:
the nature of their assets and liabilities - usually their liabilities and predominantly real and domestic, so real, domestic assets are preferable
their cashflow requirements - the individual should consider the period when asset proceeds are required ie when total expenditure exceeds other income; they should also determine the extent to which they want their investment to provide income as opposed to capital gains
variability of market values - the stability of values should not be a major factor for long-term investment, however the short term horizon of many individuals can make stability of asset values seem important
returns from different asset classes - the best value investments are probably those that have specific tax advantages; it may also be necessary to consider any "feel-good" factors
investment freedom and constraints - investment is constrained by the level of risk the individual can take on, which may depend on
the level of excess assets of the individual, as these afford investment freedom
the uncertainty of future and outgo - must have liquidity to meet need day to day needs; can use insurance to reduce need for large emergency funds
risk appetite of the investor
practical considerations e.g.:
the level of assets being too low to permit direct investment in some asset classes - investor should ensure there is adequate diversification over all
the relatively high expenses incurred when investing small amounts
a likely lack of investment expertise and information compared with professional investors
Investment Strategy - institutions
Risk can be defined in many ways:
probability of default (credit risk)
expected variability of return (market risk)
relative performance risk
probability of failing to achieve the investor's objectives (actuarial risk)
Risk appetite
The risk appetite of an institution will depend on:
nature of the institution
constraints of its governing body and documentation
legal or statutory controls
Factors influencing the investment strategy
Existing and expected future liabilities should be considered
Tactical asset allocation
Other key factors are:
tax (treatment of the asset and the investor)
statutory, legal or voluntary restrictions on how the fund may invest
size of the assets both in relation to the liabilities and in absolute terms
the expected long term return from various asset classes
statutory valuation and solvency requirements
the existing asset portfolio
the strategy followed by other funds
the institution's risk appetite
the institution's objectives
the need for diversification
Tactical asset allocation involves a departure from the benchmark position in an attempt to maximise return. This may conflict with the minimisation of risk.
Institution's preference for income or capital growth from their investments are governed by two main factors: tax and cashflow requirements
Factors to consider before making a tactical switch:
the level of free assets
the expected extra returns to be made relative to the additional risk (if any)
constraints on the changes that can be made to the portfolio
the expenses of making the switch
the problems of switching a large portfolio of assets
Developing an investment strategy
The principals of investment
A provider should select investments that are appropriate to the:
of the liabilities, and
the provider's appetite to risk
Asset-liability matching requirements - nature of liabilities
In practice the actual liability outgo in any year, or month, depends on:
the monetary value of each of the constituents, and
the probability of it being received or being paid out
Asset-liability matching requirements - selecting assets
Liabilities denominated in a particular currency should be matched by assets in the same currency, so as to reduce any currency risk
Liabilities guaranteed in money terms
Consist of benefit payments specified in monetary terms, plus expense outgo less the premium/contribution income hat is fixed in money terms
Appropriate assets are those which achieve matching (pure or approximate) or immunisation
Any free assets are not likely to be used to support a move away from the matched position
Last definition is most practical when considering investment strategy
The main features of liabilities that will influence investment strategy are:
nature -nominal or real
degree of uncertainty in timing and amounts
The following controls affecting investment strategy maybe implemented:
restrictions on the types of assets that a provider can invest in
restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
a requirement to match assets and liabilities by currency
restrictions on the maximum exposure to a single counterparty
custodianship of assets
a requirement to hold a certain proportion of total assets in a particular class, for example government stock
a requirement to hold a mismatching reserve
a limit on the extent to which mismatching is allowed at all
When selecting individual investments an important factor for an institution is the effect that an investment will have on the performance and the diversification of the total portfolio. diversification is achieved by selecting assets that have a low covariance with the rest of the portfolio. Divesification reduces specific risk.
Subject to the above, the investments should e selected to maximise the overall return (income plus capital) on the assets
The liability outgo maybe split into four categories:
guaranteed in money terms
guaranteed in terms of a price index or similar
investment linked
Liabilities guaranteed in terms of price index or similar
Consist of benefit payments specified by reference to an index, plus expense outgo less the premium/contribution income that is linked to an index
Appropriate assets are index-linked securities or real assets
Any free assets are not likely to be used to support a move away from the matched position
Discretionary benefit payments
Appropriate assets are real in order to maximise returns
The presence of free assets may thus be irrelevant unless there is not full discretion over the benefit payments, in which case they may be used to ensure that the probability of not meeting a certain level of discretionary benefits falls within an acceptable level
Index-linked benefit payments
Appropriate assets are those which replicate or closely approximate the index
Any free assets may be used to maximise returns with any profit benefiting the provider. However regulation may disallow mismatching
Active and passive management
Active - method where an investment manager has few restrictions on investment choice within a broad remit. This method is expected to produce greater returns despite extra dealing costs and risks of poor judgement
Passive - this involves holding assets closely reflecting those underlying an index or specified benchmark. the investment manager has little freedom of choice. There remains a risk of tracking errors occurring and the possibility of a poorly performing index or benchmark
Measuring active risk
Active risk is most commonly measured as a tracking error.
Historic tracking error - annualised standard deviation between actual and benchmark performance
Forward looking tracking error - annualised standard deviation between projected performance and projected benchmark performance. Especially useful when future holdings are expected to differ a lot from past holdings
Risk budgeting
Risk budgeting - a process that establishes how much risk should be taken and where it is most efficient to take that risk (in order to maximise return). With regard to investment risks, the risk budgeting process has two parts:
deciding how to allocate the maximum permitted overall risk between active and strategic risk
allocating the active risk budget across the component portfolios
In its purest form matching of assets and liabilities involves structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the outgo in respect of the liabilities under all circumstances.
Common problems with precise matching include:
uncertainty in the timing and/or amounts of either assets or liabilities
assets of long enough term may not exist
income from the assets may exceed liability outgo in the early years
Actuarial techniques - asset-liability models
An asset-liability model can be used to help set an investment strategy in line with a stated objective
The objectives should include:
a quantifiable and measurable performance target
defined performance horizons, and
quantifiable confidence levels for achieving the target
A stochastic model allows for the random nature of some of the model parameters. If the assumptions underlying the model are realistic, then a clearer picture of the appropriateness of the assets is possible
Non-actuarial techniques
Other techniques for determining an investment strategy are:
mean-variance optimisation without reference to the liabilities
basing asset allocations on market capitalisations i.e. index tracking
shadowing the strategies of other comparable institutional investors
Liability hedging
Liability hedging is where the assets are chosen in such a way as to perform in the same way as the liabilities
Immunisation is the investment of the assets in such a way that the present value of the assets minus the present value of the liabilities is immune to a general small change in interest rates
Three conditions must apply for Redington's immunisation:
present values of liability-outgo and asset-proceeds must be equal
The discounted mean term of the value of the asset proceeds must equal the discounted mean term of the liability outgo
The spread (or convexity) about the mean term of the asset proceeds should be greater than the spread of the value of the liability outgo
There are a number of theoretical and practical problems with immunisation:
Immunisation is generally aimed at meeting fixed monetary liabilities
Immunisation removes mismatching profits apart from a second order effect
The theory relies on small changes in interest rate
the theory assumes a flat yield curve and level interest rate changes at all terms
In practice, the portfolio must be constantly rebalanced
the theory ignores dealing costs
Assets of a suitably long discounted mean term may not exist
the timing of asset proceeds and liability outgo may not be known
Portfolio construction
Portfolios are typically constructed to meet two often conflicting objectives of:
reducing risk (often in terms of solvency and stability cost)
achieving high long-term returns
The process of quantifying risk often involves dividing risk into:
strategic risk - risk that the strategic benchmark does not match the liabilities
active risk - the risk taken by the individual investment managers relative to the given benchmarks
structural risk - where the aggregate of the individual investment manager benchmarks does not equal the total benchmark for the fund

Modelling and monitoring
Setting assumptions
All actuarial models need assumptions. The key factor affecting the choice of assumptions are:
the use to which the model will be put
the financial significance of the assumptions
consistency between assumptions
legislative and regulatory requirements
the needs of the client
Data requirements
The main uses of data are:
statutory returns
financial control, management information
risk management
setting provisions
experience statistics
experience analyses
premium rating, product costing, determining contributions
Main data sources:
publicly available data
internal data
Data quality
A well designed proposal form will contain unambiguous questions to help ensure correct answers are collected from policy holders
Data issues for employee benefit schemes
The actuary will make assertions as to the quality of the data
The information is provided by the sponsor, rather than being under the direct control of the actuary
Producing a solution
A model must capture the most important features of the actual situation
Requirements of a good model
A good model will:
be valid rigorous and well documented
reflect the risk profile of the business being modelled
allow for all the significant features of the business being modelled
have appropriate input parameters and parameter values
be communicable and the output verifiable
not be overly complex or time consuming to run
be capable of development and refinement
be capable of being implemented in a range of ways
Use of models for pricing - model points
A model point is a representative policy. It is usual to identify model points, which represent relatively homogeneous underlying groups of policies
A model needs to allow for all the cashflows that may arise, including:
guaranteed and discretionary benefits
cashflows arising from any supervisory requirement to hold provisions
the potential cashflows arising from options and guarantees
Use of models for pricing - the risk discount rate
Poor data can be due to:
poor management control of data recording or its verification process
poor design of the data system
The risk discount rate could allow for:
the return required by the company
the level of statistical risk (accessed analytically or by the sensitivity analysis or from a stochastic model)
Summarised data
Sometimes the actuary only has summarised data. It is not suitable for all valuation purposes e.g. valuing options and guarantees that apply on an individual basis
It is important the model is dynamic i.e. it allows for the interaction between the parameters and variables affecting the cashflows
Use of models for pricing - premiums and marketability
The premiums/charges resulting from the model need to be considered relative to the market. This may require reconsideration of the:
product design
distribution channel
profit requirement
size of market
whether to go ahead with the product
Use of models for setting future financing strategies
Modelling techniques are used by benefit schemes to determine future financing strategies
Results of model give amount and timing of future contributions
It is acceptable for a scheme to have a deficit as long as a sponsor's covenant is strong enough and sufficient assets are available to meet benefit outgo as falls due
Use of models for risk management
Models can be used to determine capital requirements to help support risks
Use of models for pricing options and guarantees
The results of a model are only as good as the model itself and the choice of the parameter values
Scenario testing involves changing many parameters in combination
A client must be made aware of the uncertainties underlying the model assumptions
A model can be a:
commercially produced product
modified existing model
new model
The time period between cashflows should be chosen to balance the reliability of the output with the speed of running the model
Developing a deterministic cashflow model
The steps involved in running a deterministic model are:
specify the purpose
collect, group and modify the data
choose the form of model
identify the parameters and variables
ascribe the parameter values
construct a model based on expected cashflows
check the goodness of fit is acceptable
fit a new model if the first choice does not fit well
run the model using selected values of the variables and values that will apply in future
sensitivity test the parameters
Developing a stochastic cashflow model
The steps involved in running a deterministic model are:
specify the purpose
collect, group and modify the data
choose a suitable density function for each stochastic variable
specify the correlations between variables
construct a model based on expected cashflows
check the goodness of fit is acceptable
fit a new model if the first choice does not fit well
run the model many times using randomly generated values of the stochastic variables
produce a summary of results
A stochastic discount rate can also be used
In theory a different rate could be used for each component of the net cashflows to allow for the different levels of risk in each cashflow. However, in practice, for simplicity, a single rate is used to reflect the average levels of risk
The risk discount rate is used to discount the future net cashflows
The actuary should consider the appropriateness of the premiums/charges given the company's business strategy and capital requirements
Use of models for assessing provisions
The valuations of a company's liabilities for regulatory purposes is likely to be carried out on each individual policy or member, rather than by using model points
Options and guarantees are likely to be priced using a stochastic model
Model and parameter error
Sensitivity analysis is used to illustrate the potential variability of the results and to identify the impact of mis-estimation of the parameter values
Goodness of fit tests help reduce model error
Alternative ways of allowing for risk
Statistical risk associated with parameter values can be allowed for in the discount rate and/or by including margins in the parameter values
For life insurance policies, the proposal form should capture the relevant underwriting information. For general insurance policies, it should capture the relevant rating factors.
The information on both the proposal and claim forms must be easy to enter into the system
The system should be able to link across proposal and claims records
Past data can be used to help verify current data
Accounting data is useful to help verify benefit outgo, contribution income and the asset value. Data on individual assets should also be checked
Checks on data
These assertions will be checked by looking at:
reconciliations of member numbers
reconciliations of benefits and premiums
movement data against accounts
validity of dates
consistency of average sum assured or premium compared with previous investigation
consistency of asset income data and accounts
the reconciliation of beneficial owner and custodian records where assets are owned by a third party
full deed audit for certain assets, eg property
consistency between start and end period shareholdings
records picked at random for spot checks
Industry-wide data collection schemes
In some countries organisations collect data. Industry-wide data is suitable for setting bases, but not for valuing an individual policy
Care needs to be taken as the data can be heterogeneous. This is because the data supplied by different companies may not be precisely comparable because:
companies operate in different geographical or socio-economic sections of the market
the policies sold by different companies are not identical
sales methods are not identical
the company will have different practices e.g. underwriting, claims settlement
the nature of the data stored by different companies will not always be the same
the coding used for the risk factors may vary from organisation to organisation
In addition problems may arise as:
the data may be less detailed/flexible
the data maybe out of date
the data quality maybe poor
not all organisations contribute
Data may also be obtained from reinsurers
Risk classification and reduction of heterogeneity
The aim is to have homogeneous data, since heterogeneity distorts results
The removal of heterogeneity needs to be balanced against having sufficient data in each group to ensure credibility
Historical and current data
Main sources used to determine assumptions are historical and current data. Sources include:
national statistics
industry data
actuarial tables
reinsurers' data
Data may not be immediately relevant to future experience. The actuary needs to consider the social and economic conditions that will apply in the future period to which the projections will relate and how those conditions will be different form those that influenced the past data. The conflict between having relevant data and sufficient data for its analysis to be statistically credible must be managed by the actuary in making a judgement about future experience
When using past data the actuary needs to consider how to deal with:
abnormal fluctuations
changes in the experience with time
random fluctuations
changes in the way in which the data was recorded
potential errors in the data
changes in the balance of any homogeneous groups underlying the data
heterogeneity within the group to whom the assumptions are to relate
Current data is also likely to be useful in setting assumptions, such as statements by governments or controlling banks, industry forecasts and the views of the companies directors eg about future salaries of the workforce
The relationship between current yields on fixed and index linked bonds is a good indicator of future expected inflation
The actuary should also be aware of the potential significance to the valuation results of errors in the assumptions. The relationships between parameters used to project income and outgo, and between the discount and projection factors, are more important than the absolute values assumed
Standard tables
National statistics are often available but won't necessarily reflect insured population
Industry level data may also be provided. Need to use with care to check that it reflects the target market and adjusts for trends
Assumptions for pricing
used to guard against future adverse experience
used to allow for profit
competitive pressure will forbid too much prudence
Risk discount rate
Usually set as the sum of a risk free rate of return plus a risk premium
The following features can make a contract design riskier, viewed as an investment:
lack of historical data
high guarantees
policyholder options
overhead costs
complexity of design
Profit criterion
A profit criterion is a single figure that summarises the relative efficiency of a contract. Common profit criterion include NPV, IRR and discounted payback period
Types of Expenses
Expense allocation
Expenses need to be allocated by:
class of business
Indirect expenses can be allocated in several ways e.g.:
premesis' costs can be allocated by floor space occupied by staff
computing cost using a charge out basis
other costs may be excluded until the end of the allocation and then allocated in proportion to other expenses
Direct expenses are often allocated to class of business using staff time sheets
Expense allocation for premium rating
Expenses can be loaded into the premium as:
a percentage of premium
a percentage of the sum assured or benefit
a fixed amount per contract
or a combination
Fixed vs variable
Direct vs indirect
Fixed - constant in short term. Variable vary by amount of business (new business written or existing business handled). Some expenses fall into a third category in between, where they are essentially fixed but can vary from time to time eg senior management costs
Direct expenses can be identified as belonging to a particular class or classes of business. Indirect expenses cannot.
Expense allocations take place for many different purposes e.g.:
analysis in the accounts
profitability (analysis of surplus)
Allocation by class of business
Allocation to function
The (non- commission) expenses can be split into:
initial expenses
maintenance expenses, including:
renewal expenses
investment expenses
termination expenses

Premiums should be adequate to cover administration costs, claims handling costs and the fixed expenses of the provider as well as the expected claims or benefits arising under the contract
Pricing and financing strategies
Cost vs Price
Incidence of monies paid in
The price of benefits is the amount that can be charged under a particular set of market conditions and may be more or less than the cost. Factors influencing the price include:
distribution channels employed
level of competition in the market
premium frequency
The main methods of financing a benefit are:
Pay-as-you-go (unfunded)
lump sum in advance
terminal funding
just in time funding
smoothed pay as you go
Once a price has been determined, it should be profit tested and market tested
Defined benefit pension schemes - amount of contributions
The approach to financing will affect the balance of risk between the party exposed to the contingent event and the provider of a financial product to mitigate the risk. Consequently this has an effect on the amount of contributions required
The cost of benefits is the amount that should theoretically be charged for them
The premium(s) or contribution(s) should be calculated as the value of the benefits and expenses plus a contribution to profit. However, this should then be adjusted to take into account other factors such as:
cost of capital
contingency margins
options and guarantees
provisioning bases
experience rating
investment income
reinsurance costs
Governments may use the tax system to make some approaches to financing more advantageous than others
Under a defined benefit pension scheme, the calculated contribution rate is typically set to meet the value of future benefits and expenses. However, the actual contribution rate may be different to the calculated rate so as to rectify any shortfall or surplus in pension schemes, or to reflect the sponsor's desire to pay less or more into the scheme
Surplus and surplus management
Surplus and surplus management
Profit - difference between revenues and expenditure. Because the long-term nature of financial service contracts, the final profit from a scheme or tranche of policies cannot be determined until all risks have gone off the books
Discontinuance terms for individual contracts
The overriding principle in determining discontinuance are they are fair to:
the policyholder or scheme member
other policy holders and scheme members
the provider of benefits
Factors for the insurer to consider in relation to discontinuance:
contracts for which to offer discontinuance terms (as determined by market practice, regulation or complexity in calculating terms)
form of the discontinuance terms offered (e.g. lump sum or paid up value)
Benefit schemes
Discontinuance terms may take the form of a transfer of a lump sum benefit out of the original benefit scheme or a continuation of benefits within a scheme
Insolvency and closure - insurance companies
Insurance companies rarely become insolvent because:
a regulator typically regularly monitors the financial position of insurance companies
insurance company regulation typically requires companies to hold a minimum level of solvency capital
Valuing Liabilities
Provisions are amounts set aside to meet future liabilities
Different bases
The strength of the basis used depends upon:
the reason for the valuation
the needs of the client
Setting assumptions for calculating provisions
The assumptions used will depend critically both on the purpose for which the provisions are calculated and the client for whom the calculation is for.
Other factors that may affect a valuation basis include:
Decisions by individuals - consider assumptions that take into account the individual's circumstances - usually realistic, but also consider a range of assumptions to communicate the risks of over- or under-contributing
Decisions by stakeholders - decisions are made based on company accounting information, likely to use realistic assumptions
Decisions relating to investments - consider a range of different assumptions and stochastic modelling
Sensitivity testing
In a life insurance context, discontinuance benefits are often based on the asset share of a policy. However, the life insurer must also take into account:
policyholder's reasonable expectations (at both short and long durations)
competitive considerations
new business disclosure
the ease of calculation of the discontinuance benefits
the cost of implementing the discontinuance terms
frequency of change of discontinuance
The purposes are:
The published accounts - the assumptions will reflect legislation and accounting principles. Matters to be considered include:
using a going concern or break-up basis
reflecting a true and fair view
the degree of prudence in the basis
Demonstrating supervisory solvency - there will be a need for:
any prescribed methods/ assumptions to be followed
The internal accounts - a best estimate set of assumptions is typically used
Calculating discontinuance benefits - a best estimate basis may be considered to be fair. Other bases may be appropriate, e.g. a more cautious basis if the aim is to encourage surrenders
Determining whether discretionary benefits can be paid - likely to err of caution so surplus is not over-stated
Setting contribution levels - the assumptions used will depend on the objectives of the parties concerned. E.g. Trustees are concerned with the security of the benefits so will want to put prudent assumptions, whereas the sponsor may not want to unduly tie up capital in the pension scheme, and so may prefer optimistic assumptions
Setting investment strategy - best estimate is typically used with sensitivity and scenario testing
Disclosure information for beneficiaries - the assumptions will reflect legislation, but a realistic basis will typically be used, with a range of results also provided
If there is an acquiring company prepared to take over the business, it will be necessary to consider:
the location of the operation
any integration of the systems platform
relocation of staff or whether there is adequate labor force available
the effect of unit costs
Liability Transfers
Contract values are highly sensitive to option pricing methods and assumptions. the assumptions used will depend on, among other things:
the state of the economy, and hence must be scenario specific
demographic factors such as age, health, employment status
cultural bias
consumer sophistication
Factors affecting the value of guarantees
This is usually achieved by starting with the risk-free rate, then adjusting for financial and non-financial risks. However, adjustment for mismatching risk is generally not made so as to achieve independence of the fair value liability valuation from the actual assets held
Two definitions of fair value are:
the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's length transaction
the amount that the enterprise would have to pay a third party to take over the liability
Approaches to valuing assets and liabilities
Used to calculate values of assets and liabilities on a market-consistent basis by applying deflator to a series of cashflows under a set of realistic scenarios
Setting assumptions or valuing options and guarantees
The most sophisticated way of valuing provisions for options and guarantees is to use a stochastic model
These methods aim to find the market value of liabilities, but in practice there is no secondary market for most liabilities. Therefore the market value cannot be found directly. instead we need to try to find market-based assumptions.
The value placed on the provisions is highly dependent on the assumptions used, which, in turn will be highly dependent on the reasons for calculating provisions
Calculating individual provisions
Reasons for calculating individual provisions include:
determining the value of liabilities for published accounts
demonstrating supervisory solvency
determining the value of liabilities for internal management accounts
valuing the provider for merger or acquisition
determining whether discretionary benefits can be paid
setting future contribution levels for a benefit scheme
valuing benefit improvements for a pension scheme
calculating discontinuance benefits
to provide disclosure information beneficiaries
influencing investment strategy
Calculating global provisions
As well as calculating provisions in respect of each individual contract, there may be a requirement to calculate an additional global provision. The purpose of this global provision may be to:
act as additional protection against insolvency
cover risks, both financial and non-financial, that cannot necessarily be attributed to individual contracts
reflect degree of mismatching of asset and liabilities
A best estimate basis might be used to calculate the value of liabilities to be transferred:
so as to achieve fairness for all parties
so as to achieve agreement between actuaries acting for different parties
to comply with legislation
Sensitivity testing can be used to help determine the extent of the margins needed in the assumptions used for valuing individual provisions and in determining the extent of the global provisions required
Guarantees may become more or less onerous on the provider over time depending on how experience develops
Setting the discount rate
In recent years there has been an increasing move towards such methods
In general, when valuing provisions for options and guarantees, a more cautious approach than normal is taken. But also consider option holder's possible behaviour, e.g. not always picking the option of greatest value
Factors affecting the value of options
Options and guarantees are not independent. Some guarantees may make options more valuable in certain scenarios
The risk of anti selection must be allowed for when valuing options
Stochastic Deflators
At the time of discontinuance, the scheme may be underfunded and the benefits provided on discontinuance may need to be reduced to reflect this
It will also be important to project the insurer's solvency position into the future using either stochastic model or a deterministic model with scenario testing. The issues that need to be addressed and modelled include:
estimation of future profits available to equity shareholders, net of tax
the current value of all surplus assets
the amount, and timing, of any loan or debt redemption
problems of staff relationships (and redundancies)
considerations relating to staff benefit schemes - particularly if schemes are in deficit
outstanding financial obligations, minority interests, tax
Insolvency and closure - sponsored benefit schemes
In the extreme event that an insurer cannot meet its liabilities, and a buyer cannot be found to take them on, there may be a statutory scheme from which some or all of the benefit payments are paid. Such a scheme is usually funded by a levy on all other providers
A benefit scheme may cease due to:
insolvency of the sponsor
a decision by the sponsor to stop financing benefit provision
If a benefit scheme is discontinued, the following options may exist for the provision of the outstanding benefit payments:
continuation of the scheme without further accrual of benefits
transfer of the liabilities another scheme with the same sponsor
transfer of the funds to the beneficiary to distinguish the liability (legislation may not allow the beneficiary to take the benefit as a lump sum)
transfer of the funds to an insurance company to invest and provide benefit
transfer the liabilities to a provider e.g. insurer or central discontinuance fund who will guarantee to pay a specified level of benefits
Reasons for performing an analysis of surplus/profit
A provider will want to analyse the surplus arising in order to:
show the financial effect of divergences between the valuation assumptions and the actual experience
determine the assumptions that are the most financially significant
show the financial effect of writing new business
validate the calculations and assumptions
provide a check on the valuation data and process, if carried out independently
identify non-recurring components of surplus
reconcile the values for successive years
provide management information
provide data for use in executive remuneration schemes
provide information for the provider's accounts
demonstrate that the variance of the parts is a complete description of the variance of the whole
give information on trends in the experience of the provider to feed back into the actuarial control cycle
Analysis of surplus or profit is a breakdown of the surplus arising over a year into it's constituent parts
To analyse the performance of a product, set of products or an entire financial service product provider over a period over a period, the actual results obtained should be compared with those that were expected
The relationship between current yields on fixed and index linked bonds is a good indicator of future expected inflation
Sources of such surplus and profit
Decrements - new business levels, withdrawals/lapses, mortality and morbidity
cashflows - premiums/contributions paid, investment income and gains, claim amounts, expenses, commision
other factors - salary growth, inflation, taxation
Levers on surplus/profit
These can be used to try to:
reduce the likelyhood of claims e.g. through good underwriting
reduce claim/benefit amounts, e.g. using reinsurance to limit claims
control expenses
increase renewals and/or reduce lapses
follow an investment policy that increases investment returns ( subject to an acceptable level of risk)
adopt an effective tax management policy
Issues surrounding the amount of surplus to distribute
Life insurance company - the factors that will affect the amount of surplus distributed are:
provision of capital
margins for future adverse experience
business objectives of the company
policy holders expectations
Benefit scheme - legislation is likely to be a major factor in determining the application of surplus or deficit. where legislation does not restrict the application of surplus or deficit, it is possible that the scheme rules will
Otherwise, the sponsor or the managers of the fund may decide how to apply the surplus or deficit. This decision will depend on the:
risk exposure of the various parties
source of the surplus or deficit
expected effect of the decision on industrial relations
Accounting and Disclosure
Accounting concepts
Interpreting accounts
In analysing accounts, attention should be paid to:
any accounting rules, guidance and practice in the country concerned
whether the accounts should be prepared on a going concern basis and should give a true and fair view
any changes in accounting practice
the basis used for the valuation of assets
any exceptional events during the accounting period
Insurance companies
Accounts can be analysed using ratios including the:
expense ratio
commission ratio
operating ratio
ratio of outward reinsurance premiums to gross premium income
Although regulation and practice may vary between countries, the main accounting concepts commonly used in drawing up financial statements are:
money measurement
going concern
business entity
dual aspect
Reporting on benefit schemes is different as benefit schemes do not generate profits or losses. In many countries information about the financial position of the scheme must be disclosed to beneficiaries in an attempt to improve the security of the provisions
Where disclosure is required by regulation, this may relate to information given to beneficiaries:
on entry
at regular intervals
once payments commence
on request
a combination of these
Also, where benefits are sponsored by a company, it is important that the company's shareholders are aware of the financial significance of the benefit obligations that exist. It is therefore common practice in many countries for these financial obligations to be shown as part of the company's accounts.
Reasons for monitoring experience
Data required for monitoring
It is desirable to review the continued appropriateness of any investment strategy at regular intervals because:
the liability structure may have changed significantly
the funding position may have changed significantly
investment performance may be significantly out of line with that of other funds
Allowance should be made for:
abnormal events
random fluctuations
The basic requirement is that there be reasonable volume of stable, consistent data, from which future experience and trends can be deduced
Use of the results
Other economic factors include expenses and salary growth. Expense analyses are covered in an earlier chapter. A salary growth analysis is likely to distinguish between general salary increases and promotional salary increases
It is likely that an investment manager will work to a performance objective in which the return is judged relative to that achieved by other managers for similar funds
Monitoring the experience is a fundamental part of the actuarial and risk management control cycles. The experience will be monitored so as to:
update assumptions as to future experience
monitor any adverse trends in experience so as to take corrective actions
provide management information
For statistical factors such as mortality and withdrawal, this will involve the calculation for each age band of the number of deaths or withdrawals) divided by the number exposed to risk of death (or withdrawal)
The results of an analysis of experience should not be used blindly. Consideration should not be given to whether the period under investigation was typical and whether the experience is likely to be representative of future experience
Life insurance
If the insurer's financial position is serious (e.g. the solvency capital requirement is not met), then the regulator may require the company to:
close to new business
establish a recovery plan (with implementation monitored closely by the regulator)
If a scheme ceases, the level of benefits that will be paid will be affected by:
rights of the beneficiaries
expectations of beneficiaries
the level of assets
At the time of discontinuance, the scheme may be:
under-funded, in which case consideration will need to be given to the priority of the different groups of members of the scheme in receiving benefits. This may be dictated by legislation or rules. an allowance should be made for the expenses involved in determining the benefit allocations
over-funded, in which case the surplus may pass back to the employer, or be used to improve the benefits of the scheme members. Consideration must be given to ensuring that members' basic rights are met before seeking to improve the benefits
The bases in order of increasing strength are: optimistic, best estimate and cautious
The best estimate basis is a basis with and equal probability of overstating or understating values
Factors affecting the strength of the basis
In the case of regulation, assumptions may be dictated by regulation or left to actuarial judgement but with requirements for disclosure
A basis other than the best estimate might be used:
due to power imbalance between the parties concerned
because of a stronger desire to proceed by one party
to recognise the need to hold margins to protect security
The value of guarantees and their influences on consumer behaviour will vary widely according to the economic scenarios and the sophistication of the market
Discounted cashflow approach: long term discount rate used to value assets and liabilities
Market value approaches: replicating portfolio approaches can be used. assets are valued at market value, aim to determine market price of liabilities and hence discount rate
In theory, financial economics can be used to find the market price of the liabilities, but it can be difficult to achieve in practice
Setting the discount rate
Discounted cashflow
Valuation of assets: Long term rate based on actual holding or notional portfolio
Asset-based discount rate
Valuation of assets: Market value
Replicating portfolio (mark to market)
Valuation of assets: market value
Replicating portfolio (bond yields plus risk premium)
Valuation of assets : market value
Valuation of liabilities: Same as long-term rate as assets
Valuation of liabilities: the discount rate is the expected return on assets, weighted by proportions held of each asset class
Valuating liabilities: rate implied by market price of investments that match liabilities - often bonds
Valuation of liabilities: Rate as in mark to market method but adjusted to take take account of higher expected returns on other asset classes
Fair value reporting
Different methods of allowing for risk in cashflows
Build a margin into each assumption
apply a contingency loading by increasing the liability value by a certain percentage
adjust the rate of return to reflect the risk in the project or liability
Different methods of calculating provisions
Statistical analysis -if many claims following a known pattern
Case by case estimate - individual assessment of claim records where there are few claims
Proportionate approach - base on amount of net premium yet to expire
An equlisation reserve may be set up to smooth results from year to year where there are low probability risks with a high and volatile financial outcome
Insurance business is subject to cyclical effects, which means that the results of one insurance company should only be compared to those of companies transacting similar types of business
The strength of the provisioning basis will affect the reported results, which makes it difficult to achieve consistency from year to year.
Benefit schemes
It is important that beneficiaries are given sufficient information about their entitlements. Disclosure could include details of the:
benefit entitlements
contribution obligations
expense charges
investment strategy
risks involved
treatment of entitlements in the event of insolvency
A number of different accounting standards exist but there are some common aims that most of these standards attempt to achieve:
recognising the realistic cost of accruing benefits
avoiding distortions resulting from fluctuations in the flow of contributions from the employer to the pension scheme
consistency of the accounting treatment from year to year
disclosure of appropriate information
Difference that exist relate to the:
relative emphasis on the balance sheet and the income statement
choice of actuarial method
flexibility in the setting of assumptions
smoothing of year to year fluctuations
amount of information to be disclosed
Possible disclosure requirements that maybe needed include:
actuarial method
value of liabilities accruing over the year
increase in the past service liabilities at the start of the year
investment returns achieved on the assets
surplus or deficit and the change in this figure over the year
benefit cost over the year in respect of any directors
membership movements
Surplus - difference between the value of the assets and the value of the liabilities. Surpluses (or deficits) may appear and disappear as the contract's experience unfolds
Surplus arising - the change in surplus over a time period. Surplus arising is equivalent to profit
Carrying out an analysis of surplus
The expected results can be modeled by using the models produced at the product development stage. The assumptions within the models should be mutually consistent
Applying the expected new business and renewal levels to such models and aggregating the results, sets of revenue accounts can be developed. The relationships between the elements of the modelled revenue accounts should be mutually consistent. These modelled accounts can be compared with the actual accounts to derive the deviation om expected
The deviation can be analysed to help answer the questions arising, particularly concerning the investment returns obtained and the product development and other costs incurred
Where surplus is to be applied to the advantage of the sponsor, or deficit is to be made good by the sponsor, a further decision would be required relating to the pace at which this will happen
Sources of risk
Types of risk
Liquidity risk
The failure of third parties to repay debts. Examples include:
default risks on bonds
counterparty risk (including settlement risk)
general debtors
Liquidity vs marketability:
marketability - how easy it is to convert an asset into cash. the amount of cash received is unimportant
Liquidity - how quickly the asset can be converted to cash at a predictable price
The principles (or cannons) of good lending relate to the:
character and ability of borrower
purpose of the loan
amount of the loan
ability of the borrower to repay
Market risk
Business risk
The decision to lend is a balance between risk and reward. Security may be used as a way of enhancing a lender's position
Major risks faced by a financial organisation:
market risk (financial risk)
credit risk (financial risk)
business risk (financial risk)
liquidity risk (financial risk)
operational risk (non-financial risk)
external risk (non-financial risk)
Liquidity risk -(for an individual or company) is the risk that although solvent they cannot meet obligations as they fall due or can secure resources only at excessive cost
Market risks - risks related to changes in investment market values or other features correlated with vestment markets. market risk can be divided into:
changes in asset values
investment market values changes on liabilities
mismatching assets and liabilities
Risk and the risk management process
Risk in benefit schemes
Risks and uncertainty in benefit schemes
The risks may relate to the level and incidence (timing) of:
investment returns
Key risks - Beneficiary:
the benefits will be less valuable than expected
the benefits will not be received at the expected (or required) time
For a defined contribution risk of inadequate benefits arises from:
investment returns being lower than expected, or expense charges higher
annuity purchase terms being poorer than expected
members' needs not being met either due to design or inflation erosion of value
Contribution/premium risks
Risks - Defined contribution schemes
the contribution/premium are unaffordable and hence not made
insufficient liquidity to make the payments in a timely manner
the contribution/premiums are linked to an inflationary factor, thereby introducing an inflationary risk
The risk management process
The risk management process
Risk management can be described as the process of ensuring that the risks to which an organisation is exposed to are the risks to which it thinks it is exposed and to which it is prepared to be exposed
Through risk management a provider will be able to:
avoid surprises
improve the stability and quality of their business
improve growth and returns by exploiting risk opportunities
improve growth and returns through better management and allocation of capital
identify opportunities arising from natural synergies
identify opportunities arising from risk arbitrage
give stakeholders in their business confidence that the business is well managed
Risk portfolios/registers
The parent company could determine its overall risk appetite and divide it between the units. However this is likely to make no allowance for the benefits of diversification
The risk management process should:
incorporate all risks (financial and non financial)
evaluate all relevant strategies for managing risk
consider all relevant constraints
exploit hedges and portfolio effects
exploit financial and operational efficiencies
Reports and systems at the enterprise level
Key principle - Defined benefit scheme. To ensure that sufficient assets are available to meet the liabilities as they fall due. The risks that need to be managed include:
inadequate funds due to underfunding (insufficient assets have been set aside)
inadequate funds due to sponsor insolvency
inadequate funds due to asset/liability mismatching
illiquid assets ie funds not available when required
risk that the benefit promise is changed e.g. by the State
members' needs not met, either due to design or inflation erosion of value
The Tail VaR could also be defined as the expected shortfall, conditional on there being a shortfall
For both schemes, there are further risks resulting in contribution/premium uncertainty. These are:
loss of funds due to fraud or misappropriation
incorrect benefit payments
inappropriate advice
administrative costs, eg to comply with legislation
decision by parties to whom power has been delegated
fines or removal of tax status resulting from a non-compliance with legislation
changes to tax rates or status
Risk measures
Involves the following steps:
grouping of risks into broad categories
development of adverse scenario for each risk group
calculation of consequences of risk event occurring for each scenario
total costs calculated are taken as the financial cost of all risks represented by the chosen scenario
Evaluation of risks - stress testing
Evaluation of risks - stochastic modelling
It is usual to report on risk by quantifying the capital requirements to protect against ruin at a particular ruin probability
Low likelyhood - high impact risks
These are often the most difficult to manage. They need to be managed in a measured way. It can be tempting to concentrate unduly on them
Enterprise risk management
Each stakeholder needs to decide upon which risks to:
reject the need for financial coverage e.g. if risk is trivial
retain, in part or full
transfer (insure or subcontract all the risk)
Risk financing
The extent of the risk transfer will depend on the:
probability of the risk occuring
existing resources of the shareholder
cost of transferring the risk and willingness of a third party to accept the risk
Assets risks - active risk measures include historic and forward looking tracking error
If risks are managed and budgeted at enterprise level then companies need a system of risk reporting across the whole enterprise. it is important to understand whether the business units are using the risk exposure allocated to them so that expected diversification benefits are actually realised
Stress testing involves testing for weakness in a portfolio by subjecting it to extreme market movements. there are two types of stress test:
In order to determine the capital necessary to hold for such risks, the company will consider its own risk tolerance eg withstand 1/200 risk event over a period of one year
Evaluation of risks - scenario analysis
These risks:
can only be diversified in a limited way
can be passed to an insurer/ reinsurer
can be mitigated by management control procedures
Used when a full mathematical model is inappropriate
Risks and uncertainties in benefit schemes affect both beneficiary and the sponsor
If there is a shortfall in the defined benefit schemes, the sponsor maybe required by legislation to make extra contributions/premiums. Associated risks include:
lack of liquid funds
excessive contributions/premiums, which the sponsor may not be able to afford
Investment risks
Investment risks in a benefit scheme include:
uncertainty over the level and incidence of income
uncertainty over the level and incidence of capital
reinvestment risk arising from mismatching assets and liabilities
default risk
taxes and expenses
benefits are not appreciated due to poor investment returns
inflation erosion of value
liquidity risk
lack of diversification
Extra risks in a hybrid scheme
not knowing whether the guarantee will bite or not
the uncertain cost of the guarantee
additional complexity in the area of administration, investment, regulation, valuation and communication
Pricing and insuring risks
Risk classification
Risk appetite maybe related to:
existing exposure to the risk
the culture of the individual/company
structure of the company (mutual, proprietary,subsidiary,parent)
Pooling risk
Accounts can be analysed using ratios including the:
expense ratio
commission ratio
operating ratio
ratio of outward reinsurance premiums to gross premium income
Risk classification is a tool for analysing a portfolio of risks by their risk characteristics, such that each subgroup of risks represents a homogeneous body of risk. Risk classification helps the provider to:
charge a more accurate premium for the risks to be covered
eliminate unnecessary aspects of contract design and to focus cover
A risk is insurable if:
a policyholder has an interest in the risk
the risk is of financial and reasonably quantifiable nature
the claim amount payable is commensurate with the size of the financial loss
Benefit risks
Risks - Defined benefit schemes. Costs and contributions/premiums are likely to be different. Costs will not be own until no future liabilities exist. Future contributions/premiums are unknown and will depend on:
the amount of the promised benefit
the probability of individuals being eligible to receive the benefits
the effect of inflation on the level, or the real level of the benefits
the investment return achieved on the contribution/premiums (net of tax and expenses, if appropriate)
Other uncertainties arise in relation to:
the security of the sponsor and ability to make good on any shortfall
model, parameter and data error
the strength of the sponsor promise (covenant)
The risk management process consists of risk:
identification (of risks that threaten the income or assets of an organisation)
measurement (probability and severity)
control (mitigation to reduce the probability/severity of a loss)
financing (determining the "cost" of a risk and the availability of capital to cover the risk)
monitoring (regular review and assessment of risks together with an overall business review to identify new/previously omitted risks)
Risk control
Expected shortfall (Tail VaR)
1- Identify "weak areas" in the portfolio and investigate the effects of localised stress situations by looking at the effect of different combinations of correlations and volatilities
2 - to gauge the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are "stressed"
Full stochastic model is a natural extension of stress testing but can be complex and impractical in many cases
The model is often limited by one of the following approaches:
restrict the duration (or time horizon) of the model
limit the number of variables modelled stocastically, use a deterministic approach for the other variables
carry out a number of runs with a different single stochastic variable and then single deterministic run using all the worst case scenarios together
The fact that different stake holders have different appetites for risk enables risks to be transferred between different entities in exchange for a monetary payment
Individuals insure as protection against the uncertainty over the occurrence and cost of financial events
Insurable risk
The following criteria are also desirable for a risk to be insurable:
individual risks should be independent
the probability of the event occurring should be relatively small
large numbers of similar risks should be pooled to reduce variance
there should be a limit on ultimate liability undertaken
moral hazard should be eliminated as far as possible
there should be sufficient existing data/information in order to quantify risk
Systematic risk - affects an entire financial system/market and cannot be diversified away.
Diversifiable risk - arises from an individual component of a financial market or system and can be diversified away
Credit risk
Business risk is specific to business undertaken. Examples include:
poor underwriting standards
poor claims experience
providing finance for a project that turns out to be unsuccessful
exposure to a particular risk being greater than expected
Operational risk and external
Operational risk refers to the risk of a loss resulting from inadequate or failed internal processes, people and systems or from external events
Operations risk can arise from:
inadequate internal processes, people and systems
dominance of a single individual (dominance risk)
reliance on third parties
the failure of plans to recover from an external event
Operational risks can be controlled or mitigated by the organisation
External risk
External risk arises from external events such as storm, fire, flood or terrorist attack. In general these are systematic (ie non-diversifiable) risks.
There are also risks to the state, in particular, the risk of having to put right any losses incurred
Key risks - Sponsor:
costs greater than expected
payments will be required at an inopportune time
For both schemes, there are further risks resulting in benefit uncertainty. These are:
default by sponsor/provider
failure by sponsor/provider to pay contributions/premiums in a timely manner
takeover of the sponsor/provider
decision by the sponsor/provider that the benefits will be reduced
inadequate communication by sponsor/provider with beneficiaries
general economic mismanagement by a sponsor/provider of assets and liabilities
Overall security risks
Hybrid schemes
Depending on the nature of the underpin (defined benefit or defined contribution) and how likely the underpin is to bite, the risks will be more akin to one type of scheme than the other
Risk appetites and markets for risk
Different stakeholders will have different risk appetites. It is important to understand your client's risk appetite
Risk appetite will also vary within a class of stakeholders e.g. dependent on features of a particular individual or a particular company
Sufficient capital is needed if a risk is to be retained, individuals rarely have sufficient capital to absorb the consequences of a risk event occuring
Where there is a good market for risk transfer, the system is said to be risk efficient
Insurers and reinsurers take on risks in return for premium because doing so can combine or pool many risks together. this means that the law of large numbers takes effect, which implies that actual results are increasingly likely to be close to expected results, which results in greater certainty (lower volatility) for the insurer
The price accepted for a risk must be adequate, allowing the risk taker to continue in business and also to provide and contribution to profit
The main tools for risk management are:
control measures to reduce likelihood of risk occurring
control measures to mitigate consequences of risk event
Risk management should be co-ordinated in order to be capital efficient and to reduce the total cost of risk
A company's business unit might:
carry out the same activity but in different locations
carry out different activities at the same location
carry out different activities in different locations
operate in different countries
operate in different markets
be separate companies in a group, which each have their own business units
A preferable approach is to establish group risk management as a major activity at the enterprise level
A stakeholder should establish a risk portfolio or risk register, recording the impact and probability of each risk
The risk portfolio can then be extended to indicate how the risk was dealt with:
retained (and how much capital was required to support it)
mitigated (with a revised risk assessment of the remaining risks)
diversified ( with a revised assessment of the remaining combination of risks)
Liability risks - commonly measured by carrying out an analysis of actual vs expected experience
Value at Risk (VaR) - the potential loss or underperformance over a given time period with a given confidence interval
The expected shortfall is the expectation of losses below a certain level. If the specified level is a percentile point on the distribution then this is called the Tail VaR
Reporting on risk
The main issues facing providers of financial benefits in completing the assessment are:
Should the ruin probability be expressed over a single year or whole run-off of business
A stochastic model with more than two stochastic variables is impractical, so it may be better to use a correlation matrix instead
Interactions between risks should be dealt with
Some risks, particularly operational risks, are highly subjective
Using past data to estimate future consequences needs to be undertake with caution
Risk management tools and capital management
Risk management tools
Reinsurance - benefits and costs
This is likely to be lower than the cost of the reinsurance, as the reinsurance premium will include loadings for profits and contingencies
Under proportional reinsurance, the reinsurer covers an agreed proportion of each risk. This proportion may:
be constant for all risks covered ie (quota share)
vary by risk covered (ie surplus)
Both forms have to be administered automatically and therefore require a treaty
Non-proportional re insurance
A surplus treaty specifies a retention limit and a maximum level of cover available from the reinsurer. The proportion of risk ceded is then used in the same way as for quota share
Capital management
Capital management
Capital needs- individuals
The Basel Accord
A regulatory solvency capital requirement is the total of:
the margin between the best estimate basis and the regulatory liability valuation basis
an amount of additional capital in excess of the regulatory provision
Capital is needed by companies to:
provide a cushion against fluctuating trading volumes
finance expansion
finance stock and work in progress
obtain premises, hire staff, purchase equipment (start-up capital)
Regulatory capital
Quota share is widely used by ceding providers to:
spread risk
write larger portfolios of risk
encourage reciprocal business
Solvency II
Companies can use internal models:
to calculate economic capital using different risk measures eg VaR and TailVar
to calculate levels of confidence in the level of economic capital calculated
to apply different time horizons to the assessment of solvency and risk
to include other risk classes not covered in the standard model
Economic capital
It is an internal, rather than a regulatory, capital assessment
Capital management tools
Has same capital needs as other plus additional requirements due to long term nature of products. Additional requirements needed to:
meet benefits before sufficient premiums/contributions are received
meet development expenses
hold a cushion against unexpected events
meet statutory requirements (fund new business strain)
invest more freely (mismatch)
achieve strategic aims
smooth reported profits
sell products with guarantees
demonstrate financial strength to customers and advisers
Capital needs - the State
Using the standard model has the advantage that the SCR calculation is less complex and less time-consuming. however, the standard model has the disadvantage that it aims to capture the risk profile of an average company, and approximations are made in modelling risks which mean that it is not necessarily appropriate to the actual companies that need to use it
Solvency II is also based on two levels of capital requirements:
Minimum Capital Requirement (MCR) - the threshold at which companies will no longer be permitted to trade
Solvency Capital Requirement (SCR) - the target level of capital below which companies may need to discuss remedies with their regulators
Internal models aim to create a stochastic model that reflects a company's own business structure
In an economic balance sheet:
assets and liabilities should be valued at market rates, and excess of the assets over liabilities (ie the available capital) should be compared to the economic capital requirement
one way to calculate the market value of liabilities is to use the present value best estimate basis and add on a risk margin
Internal models
Typically it will be determined based upon:
the risk profile of the individual assets and liabilities in its portfolio
the correlation of the risks
the desired level of overall credit deterioration that the provider wishes to be able to withstand
Internal models are used to calculate economic capital requirements and may be used to determine the Solvency II SCR (provided the internal model gains regulatory approval)
In assessing whether, and how much, to reinsure, the actuary can place a realistic estimate on the value of the benefits that would be paid by the reinsurance provider
The evidence needs to be interpreted by specialist underwriters. Applicants whose state of health reaches the required standard can be offered the company's standard terms for the particular contract. Other applicants will be offered special terms. Which might include:
an addition to the premium
a reduction to the benefit
an exclusion clause
declining the applicant (either on a temporary or permanent basis)
Risk can be managed through diversification within the following:
lines of business
geographical areas of business
providers of reinsurance
investments - asset classes
investments held within a class
Claims control systems mitigate the consequences of a financial risk that has occurred by guarding against fraudulent or excessive claims
Types of reinsurance
Surplus cover enables a ceding provider to write larger risks, which might otherwise be beyond its writing capacity. It enables the ceding provider to "fine-tune" its experience for the class concerned
Underwriting can be used to manage risk in the following ways:
It can protect from anti-selection
It will enable a provider to identify risks for which special terms need to be quoted
For substandard risks, the underwriting process will identify the most suitable approach and level for the special terms to be offered
It will help to ensure that all risk are rated fairly
It will help in ensuring that claim experience does not depart too far from that assumed in the pricing of the contracts being sold
For larger proposals the financial underwriting procedures will help to reduce risk from over insurance
Capital management of a financial benefit provider involves:
ensuring sufficient solvency and cashflow to meet:
existing liabilities
future growth aspirations
maximising the reported profits
Economic capital is the amount of capital that a provider determines is appropriate to hold given its assets, its liabilities, and its business objectives
Two main types:
The benefits of reinsurance include:
a reduction in claims volatility and hence
smoother profits
reduced capital requirements
an increased capacity to write more business and achieve diversification
the limiting of large losses arising from:
a single claim on a single risk
a single event
cumulative events
geographic and portfolio concentrations of risk
and hence:
reduced risk of insolvency
increased capacity to write larger risks
access to the expertise of the reinsurer
Underwriting at the proposal stage
Claims control systems
Techniques for managing options and guarantees include:
liability hedging
derivatives purchased over-the-counter
option pricing methods
The State does not have the same capital needs as other providers as it can usually raise funds to meet i liabilities through:
printing money
Nevertheless, the state will hold gold and foreign currency reserves to support:
fluctuations in the balance of payments and economic cycle
timing differences in income and outgo
A proprietary insurer (owned by shareholders) can raise funds through the issue of shares or debt securities
The range of financial tools available to poviders to help them in their capital management include:
reinsurance - to reduce the amount of capital required
financial reinsurance (FinRe) - a reinsurance arrangement that provides capital, typically by exploiting some form of regulatory, solvency or tax arbitrage
securitisation - which in its most general form involves converting an illiquid asset into tradable instruments
subordinated debt
banking products - including liquidity facilities, contingent capital, senior unsecured financing and derivatives
equity capital
internal restructuring - including merging funds, changing assets, weakening the valuation basis, deferring surplus and retaining profits
The Basel Accord set requirements for the amount of capital that banks need to hold to reflect the level of risk in the business that they write and manage
Solvency II is also based on three pillars:
quantification of risk exposures and capital requirements
a supervisory regime
The SCR may be calculated using a prescribed standard model or a company's internal model
Proportional reinsurance
The disadvantages of quota share are:
cedes same proportion of low variance and high variance risks
cedes the same proportion of each risk, irrespective of size
passes a share of any profit to the reinsurer
The retention limit maybe fixed for all risks or variable at the discretion of the cedant
Under excess of loss reinsurance the reinsurer agrees to indemnify the ceding company for the amount of any loss above a stated excess point. usually, the reinsurer will give cover up to a stated upper limit, with the insurer purchasing further layers of XL cor, which stack on top of the primary layer, from different reinsurers
There are different forms of non-proportional (ie excess of loss, XL) reinsurance:
risk XL
aggregate XL (including stop loss)
catastrophe XL
stop loss
Risk XL relates to individual losses. It affects only one insured risk at any one time
Aggregate XL covers the aggregate of losses, above an excess point and subject to an upper limit, sustained from defined peril (or perils) over a defined period, usually one year.
Stop loss is a form of aggregate XL that provides cover based on total claims, from all perils on a ceding company's whole account.
Catastrophe XL pays out is a "catastrophe" as defined in the reinsurance contract occurs. There is no standard definition of what constitutes a catastrophe
The main uses of excess of loss reinsurance are:
to permit a ceding provider to accept risks that could lead to large claims
to stabilise the technical results of the ceding provider by reducing claims fluctuations
to reduce the risk of insolvency from large losses
Alternative risk transfer (ART)
ART is an alternative to traditional reinsurance. it involves tailor made solutions for risks that the conventional reinsurance market would regard as uninsurable or does not have the capacity to absorb. Example of ART contracts include:
discounted covers
integrated risk covers
securitisation eg catastrophe bonds
insurance derivatives
Financial providers may see ART contracts as providing more effective risk management. reasons why providers take out ART contracts include:
provision of cover that might otherwise be unavailable
stabilisation of results
cheaper cover
tax advantages
greater security of payment
management of solvency margins
more effective provision of risk management
as a source of capital
Diversification can also be achieved by entering into reciprocal reinsurance arrangements
Underwriting generally refers to the assessment of potential risks so that each can be charged an appropriate premium
Life insurance initial underwriting is likely to involve the following:
medical underwriting - assessing the applicant's health
lifestyle underwriting - assessing the impact of lifestyle (eg occupation, leisure pursuits, country of residence) on the level of risk
financial underwriting - to reduce the risk of over insurance as described above
Management control systems
Management control system include:
data recording
accounting and auditing
monitoring of liabilities taken on
options and guarantees
Managing options and guarantees
Capital is needed by individuals to:
provide a cushion against unexpected events
save for the future
Capital needs - companies
Capital needs - providers of financial services products
Meeting capital needs
A mutual insurer (owed by policyholders) has less access to the capital markets than a proprietary
Reasons for monitoring investment performance and strategy
It is also important to note any other constraints that may have affected the manager's performance, such as a shortage of cashflow within the provider
The data ideally needs to be divided into sufficiently homogeneous risk groups, according to the relevant risk factors. However, this ideal has to be balanced against the danger of creating data cells that have too little data in them to be credible
As well as data on the feature being assessed, it is necessary to have data on the exposed to risk, divided into the same cell structure as the experience data
Analysis process
The results can then be compared with assumptions or standard tables (if these exist)
For economic factors such as interest rates and investment returns, the analysis is simply a comparison between the actual returns and those assumed
Monitoring and control cycles
Monitoring of experience is fundamental to effective implementation of the actuarial control cycle and the risk management control cycle. this is an iterative process as may result in:
changes to assumptions or models used eg in pricing, setting contributions and provisioning
a change in the assessment of the risks faced by a provider or in its risk management strategy
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