Chapter 1 Summary – How to do a professional job
Meeting business needs
One of the prime roles of actuaries is in helping stakeholders identify the financial risks
they face and helping them to manage and mitigate those risks.
Statutory roles
In some territories there are statutory roles that can only be taken by actuaries. The
statutory roles for actuaries mainly relate to the certification of the adequacy of the
valuation of assets and liabilities for a life insurer, general insurer or pension scheme.
Doing a professional job
An actuary must act in a professional manner with integrity and with detachment from
his or her own personal circumstances. An actuary must develop a direct, personal and
trusting relationship with a client in order to advise on the most suitable solution for
that particular client. An actuary should also consider the public interest.
In carrying out a task to meet a client’s needs, an actuary will:
•
ensure he/she is familiar with the context in which he/she is going to operate
•
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
•
decide a method
•
set assumptions
•
arrive at "the solution"
•
check the solution (and get somebody else to check it)
•
communicate the answer
•
consider the professional implications of the work being done
The actuarial control cycle
The actuarial control cycle may be presented as three elements that form a continuous
process:
•
specifying the problem
•
developing the solution
•
monitoring the experience
The actuary uses models to determine optimal decisions on the basis of assumptions
made about future experience. The process of monitoring the experience and updating
the assumptions in the models ensures that the decisions remain focused and as nearoptimal as is possible in practice.
This process must be managed in the context of the general commercial and economic
environment in which stakeholders operate.
The actuary’s role in this process should always be carried out with the highest
standards of professionalism.
Chapter 2 Summary - Stakeholders
Stakeholders
There are many stakeholders who actuaries can advise including:
•
insurance company - policyholders and prospective policyholders, board of
directors, shareholders, creditors, auditors
•
benefit schemes - members (and their dependants), sponsors, trustees, auditors
•
employers
•
employees
•
government
•
regulators
•
investment fund managers
•
members of investment schemes
•
sponsors of capital projects
•
banks
In many cases the 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.
The stakeholders listed above have a wide range of interests and functions on which
actuaries can provide advice.
There are different types of advice that can be given. These include:
•
indicative advice
•
factual advice
•
recommendations
Chapter 3 Summary – Providers of benefits
Benefit providers
Benefits may be provided by:
•
the State
•
employers
•
individuals
•
financial institutions or other corporations
Range of benefits
A range of benefits is available to cover:
•
events unpredictable in timing
•
immediate consumption
•
events predictable in time
•
accumulation of disposable income and capital
State
The major role played by the State is:
•
direct provision of benefits
•
education
•
encouragement or compulsion for other providers
•
regulation of provision
The State can also provide financial instruments. e.g. the issue of bonds.
Employers
Employers have a variety of reasons for sponsoring benefit provision:
•
compulsion or encouragement from the State
•
paternalism
•
to meet business objectives, eg attract and retain good staff
•
to pool expenses and expertise
Benefits can be provided through a formal employer-sponsored scheme. This can
ensure a consistent approach across employees or help the employer target certain
groups. eg long servers or high fliers. Such schemes could be set up to offer members a
choice of benefits.
Schemes do not have to be backed by a single employer but can be sponsored jointly by
many employers. e.g. industry-wide schemes.
Individuals
Apart from being beneficiaries, individuals also finance benefit provision. The motive
for this can be:
•
compulsion by the State or the employer
•
encouragement from the State or the employer
•
the individual’s personal preferences
The means can be formally structured savings plans, which often have the advantage of
being restricted for that sole purpose. Alternatively, individuals can make informal
unstructured arrangements.
Pooling of resources by individuals for mutual benefit is also seen. eg 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 Institutions and other Corporations
Benefits are often provided by financial institutions either via employer-run schemes or
directly to individuals.
Institutions are also pro-active in highlighting need to individuals.
Chapter 4 Summary – Risks and uncertainty
Risk and uncertainty
Risk and uncertainty affect the beneficiary and the sponsor. The risks m ay relate to:
•
the level and incidence of benefits
•
the level and incidence of contributions/premiums.
The State may be at risk of having to put right any losses incurred.
Benefits
For a defined benefit scheme a key principle is to ensure that sufficient assets are
available to meet the liabilities as they fall due. The risks that need to be managed
include:
•
underfunding ie insufficient assets have been set aside
•
risk of illiquid assets
•
risk that the benefit promise is altered
•
inadequate benefits, either due to design or inflation eroding the value
For a defined contribution scheme the risk of inadequate benefits arises from:
•
investment returns are lower than expected, or expense charges higher
•
guarantee risks when purchasing the benefits such as annuities
•
poor planning so that the design does not meet the true needs
•
inflation reduces the purchasing power of contributions/premiums
Contributions/premiums
For defined contribution schemes the risks are:
•
the contributions/premiums are not made due to the financial circumstances of
the sponsor
•
The contributions/premiums are linked to an inflationary factor, thereby
introducing an inflationary risk.
For defined benefit schemes it must be remembered that cost and contributions are
likely to be different. Costs will not be known until no future liabilities exist. This
distinction introduces risks. Contributions/premiums will vary according to:
•
the benefits members accrue
•
the benefits members are eligible to receive
•
the benefit options available
For funded schemes other uncertainties arise with:
•
the assumptions and model used
•
insufficient assets having been set aside to meet future benefit payments
•
excessive assets having been set aside
For hybrid schemes there is the increased uncertainty as to whether any guarantee will
apply in the future and how it should be allowed for.
Other factors affecting uncertainty
There are also a number of further factors affecting risk via:
•
uncertainty of contributions
•
uncertainty of benefits
•
sponsor mismanagement
•
inappropriate advice
Return on capital
Return on capital can affect the level/incidence of benefits and/or the level/incidence of
contributions.
The risks that affect the overall return on capital can be broken down into:
•
income risk
•
capital proceeds risk
•
reinvestment risk
•
risk of default
•
mismatching of assets relative to liabilities
•
expense and taxation risk on net return
•
appreciation of benefits by recipients
•
security
•
strength of the sponsor/provider
Chapter 5 Summary – Managing risks
The role of insurance and reinsurance
Individuals insure as protection against the uncertainty over the occurrence and cost of
financial events.
Insurers reinsure to:
•
limit exposure to risk
•
avoid single large losses smooth results
•
make use of available expertise
•
increase capacity
•
make use of financial assistance
General insurance principles
A risk is insurable if:
•
the policyholder has an interest in the risk
•
the risk is of a financial and reasonably quantifiable nature
Pooling risks together reduces uncertainty and is the main reason why insurers and
reinsurers are able to take on risk. This is a result of the law of large numbers.
The following criteria should be met:
•
individual risks should be independent
•
probability of event occurring should be relatively small
•
large numbers of similar risks should be pooled to reduce variance
•
limit on ultimate liability undertaken
•
moral hazard should be eliminated as far as possible
•
sufficient existing data/information in order to quantify risk.
Types of insurance typically required by an industrial company
A company might require the following general cover:
•
Employers’ Liability
•
Public Liability
•
Fleet Motor 3rd party liability and damage to goods in transit
•
Product Liability
•
Commercial Buildings and Contents
•
Business Interruption
•
Professional Indemnity
•
Pecuniary Loss
•
Other. eg Project Insurance.
Chapter 6 Summary - Marketing
Financial products
The main types of financial products, schemes, contracts and transactions fall into the
following categories:
•
insurance contracts
•
pension schemes
•
investment schemes
•
derivatives
•
reinsurance contracts
Stakeholder needs
A good way of looking at marketing is to consider it from the customer’s point of view.
It is important to differentiate between a customers’:
•
emotional needs and
•
logical needs
A customer’s logical needs can be analysed as follows:
•
protection
•
accumulation for a purpose, eg an income in retirement
•
accumulation for a purpose as yet unknown out of any remaining disposable
income or capital
It is also important to distinguish between:
•
real and perceived needs
•
current and future needs
Although customers’ needs can be complicated, this does not mean that products should
be complicated. Instead products should be simple, but there may need to be a large
number of them to meet the specific needs of all customers.
Pension schemes
A defined benefit pension scheme is one where the scheme rules define the benefits
independently of the contributions payable, and benefits are not directly related to the
investments of the scheme. The scheme may be funded or unfunded.
A defined contribution scheme is one providing benefits where the amount of an
individual member’s benefits depends on the contributions paid into the scheme in
respect of that member, increased by the investment return earned on those
contributions.
Chapter 7 Summary - Life insurance products
The main life insurance policy investment types are:
•
without-profit
•
with-profit
•
unit-linked
•
index-linked.
Endowment assurance
A pure endowment assurance provides a benefit on survival to a known date and hence
operates as a savings vehicle, for example to provide a lump sum on retirement, or a
means of repaying a loan.
An endowment assurance also 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
A whole life assurance will provide a benefit on the death of the life insured whenever
that might occur.
Term assurance
A term assurance provides a benefit on the death of the life assured provided it occurs
within the term selected at outset. Term assurances do not normally have any benefit
paid on early termination.
Convertible or renewable term assurance contracts
These contracts combine a term assurance with the certainty of being able either to
convert to a permanent form of contract (ie an endowment or whole life assurance) or
to renew the original contract for a further period, all without further evidence of health
being provided (unless the benefit level is increased).
Immediate annuity
An immediate annuity involves a single premium purchasing an income, which
commences immediately after purchase.
Deferred annuity
Deferred annuities can be used when there is time between the date of purchase and the
date when the income is required to start. The contract can be paid for either by a single
premium or by regular premiums during the deferred period.
Long-term sickness insurance
The contract enables individuals to provide an income for themselves and their
dependants during periods of incapacity due to accident or illness. Such contacts
typically terminate at retirement age.
Critical illness
The contract provides a cash sum on the diagnosis of a "critical" illness as defined by
the policy documents.
Long-term care
The contract can be used to help provide financial security against the risk of needing
either home or nursing-home care as an elderly person. ie post-retirement.
Chapter 8 Summary - General insurance products
Liability insurance
Liability insurance provides indemnity where the insured, owing to some form of
negligence, is legally liable to pay compensation to a third party.
The main types of liability insurance are:
•
employers’ liability
•
motor third party liability
•
public liability - often linked to other types of insurance such as property,
marine etc
•
product liability
•
professional indemnity
Property damage insurance
The main characteristic of property damage insurance is to indemnify the policyholder.
However, here the indemnity is against loss of, or damage to, their own material
property.
The main types of property that are subject to such damage are:
•
residential building (eg house)
•
moveable property (eg contents of house)
•
commercial building ( eg office)
•
land vehicles (eg car)
•
marine craft
•
aircraft
Financial loss insurance
The benefit provided by financial loss insurance is indemnity against financial losses
arising from a peril covered by the policy.
Financial loss insurance can be categorised as follows:
•
pecuniary loss
•
fidelity guarantee
•
business interruption cover, also known as consequential loss
Fixed benefits
The insurance products in this category are:
•
personal accident
•
health
•
unemployment.
Chapter 9 Summary - Reinsurance products
Reinsurance contracts
When obtaining reinsurance insurers cede risks either:
•
facultatively or
•
by treaty
Under facultative reinsurance, each individual risk on which reinsurance is required is
offered separately to a reinsurer. There is no obligation for the insurer to offer the
business: neither is the reinsurer obliged to accept it.
Treaties allow the insurer to place reinsurance automatically. The terms and conditions
of the treaty are carefully laid down so that both parties know exactly where they stand.
Treaties are usually written on an obligatory/obligatory basis but occasionally may be
written as facultative/obligatory.
.
Proportional reinsurance
Under proportional reinsurance (or original terms), the reinsurer covers an agreed
proportion of each risk. This proportion may be:
•
constant for all risks covered (ie quota share)
•
at the discretion of the ceding company to some extent (ie surplus)
Both forms have to be administered automatically, and therefore require a treaty.
Proportional reinsurance reduces the size of the ceding company’s net account, and so
it is used mostly as a means of accepting a larger size of risk than would otherwise be
possible.
Non-proportional reinsurance
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 cover,
which stack on top of the primary layer, from different reinsurers.
There are three main types of excess of loss reinsurance:
•
risk XL
•
aggregate XL
•
catastrophe XL
Stop loss is a form of aggregate XL that provides cover based on total claims, from all
perils, arising on a class of business over a specified period.
Financial risk reinsurance or financial reinsurance involves less underwriting risk
transfer and more investment or timing risk transfer from the ceding company than is
customary in reinsurance.
Chapter 10 Summary - Regulatory regimes
Aims of regulation
The principal aims of the regulation of financial services are to:
•
correct market inefficiencies
•
promote efficient and orderly markets
•
protect consumers of financial products
•
maintain confidence in the financial system
•
help reduce financial crime
The role of the regulator also covers the need to promote public understanding of the
financial system.
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 and also perhaps
reduced competition and reduced access to different types of investment.
Functions of a regulator
The main functions of a regulator are typically:
•
setting and reviewing 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, to enable them to make
appropriate investment decisions
Areas addressed by regulation
Regulation may seek to address:
•
information asymmetries
•
conflicts of interest
•
lack of consumer negotiating power
•
capital adequacy
•
competence and integrity
•
the provision of compensation
•
other issues
Forms of regulatory regime
Amongst the possible forms of regulatory regime are:
•
prescriptive regimes - with detailed rules as to what may or may not be done
•
“freedom with publicity”
•
outcome-based regimes
•
unregulated markets - where 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
In practice, many regulatory regimes are a mixture of some or all of these systems.
Chapter 11 Summary - External environment
Legislation - regulation
•
requires (compulsory) insurance in certain circumstances
•
influences the types of product available
•
regulates the sales process
State benefits
•
raise employers awareness of the need to top up State benefits
•
raise 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, make individuals feel less wealthy and thus less able to purchase
their own cover
Tax
•
The form of benefits within products will reflect the manner in which they are
taxed.
•
Product innovations may be designed to avoid paying tax, eg inheritance tax.
•
Savings may be directed towards the most tax-effective forms (ie preference for
income or capital gains) or tax shelters (eg ISAs).
Accounting standards
Reporting requirements may influence:
•
an employer’s provision of employee benefits
•
the range of products marketed
Corporate governance
The features of a good corporate governance framework:
•
encourages managers to act in the best interests of stakeholders
•
incentivises managers accordingly
•
monitors effectiveness
•
utilises non-executive directors
The corporate governance structure may influence the way in which stakeholders’
needs are met.
Corporate structure
Mutuals
•
no shareholders
•
better benefits for the same cost (as proprietary)
•
can’t readily raise finance by usual methods
•
certain products may be restricted or more highly priced (especially those that
are capital intensive)
Product pricing is either “at cost” or takes allowance for surplus distribution to withprofit policyholders.
Proprietary/Public companies
These benefit from easier access to capital markets for finance and may benefit from:
•
economies of scale
•
more dynamic management
Private companies
•
may find the Same difficulties as mutuals in raising capital, but
•
benefit from a close involvement of the owners
All proprietaries have the issue of how to distribute surplus between shareholders and
the with-profit policyholders.
Commercial requirements
Commercial requirements relate to either the need by employers to offer employee
benefits or 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
these and/or catastrophes or economic shocks lead to
•
insurers leaving the market or reducing their involvement, recovery of “hard”
premium rates and losses, or
•
reduced solvency and the need for capital.
Changing social trends
These impact on the financial products, schemes, contracts and transactions available.
Environmental issues
These impact upon public views and thus:
•
the actions of advocacy groups and government and
•
the choices of individual participants in the investment markets, therefore
influencing:
-
the products that providers and operators offer and promote and
-
the way that they communicate
Lifestyle considerations
As the population changes so the needs for financial products change. Such changes
include the ageing of individuals and general increased life expectancy.
International practice
Providers may look to see if overseas products can be replicated in the domestic
market. Differences in taxation and legislation often act as a barrier.
Technological change
The way in which products are provided has been heavily impacted by technological
changes, especially in connection with the emergence of the internet and widespread
use of mobile phones.
Chapter 12 Summary - Project management
Managing successful projects
As actuaries, we are often involved in a team to manage a project.
The key factors in managing a successful project include:
•
a clear definition of the project including objectives, roles and responsibilities
•
careful planning
•
risk analysis
•
regular monitoring of progress against objectives
•
excellent communication and support between all parties
•
a strong leadership team
A good project management team will keep clear documentation and audits of changes.
A key document is called the written strategy. This document contains details of the:
•
project objectives and required performance standards
•
scope of the project - time, budget and responsibilities
•
financing of the project
•
risks involved
•
milestones
•
policies for financing, risk management, legal, insurance, communications,
information technology
The project team
The ultimate owner of the project is called the project sponsor. The project sponsor is
responsible for the scheduling, ie ensuring that the key milestones have been reached at
the agreed times.
The rest of the project team should be competent and committed to the success of the
project. Where possible, the 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
Chapter 13 Summary - Capital project appraisal
Definition
A capital project is any project that involves the creation of a new asset - either from
scratch or by transforming an existing asset. It need not involve the construction of a
physical asset.
The initial appraisal
The main purpose of an initial capital project appraisal is to ascertain whether a project
satisfies the criteria that have been established by the sponsoring organisation for
projects that it is prepared to authorise. The criteria are usually expressed in terms of:
•
financial results
•
synergies with other projects
•
political constraints
•
sufficient upside potential
•
use of scarce resources
Financial criteria may be expressed in terms of:
•
NPV
•
IRR
•
payback period
•
discounted payback period
If the above criteria are satisfied, the project is accepted and moves into a detailed
appraisal process.
Risks
Specific risk or probabilistic risk can be thought of as the element of risk that can be
eliminated either by repeated investment in the same project, or failing this by
diversification over a number of different projects.
Systematic risk is that 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. It is also sometimes known as non-diversifiable or market risk
Specific risk should be allowed for using a process of specific risk analysis. This
consists of identifying and quantifying the risks, where possible mitigating the risks and
managing any residual risks that remain. Systematic risk is usually reflected in the
choice of risk discount rate used to calculate the net present value of the project.
Specific risks must be:
•
identified
•
analysed
•
mitigated
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:
•
the probability of occurrence
•
the financial consequences
•
their interdependence
•
their controllability
Six key methods of mitigating specific risk include:
•
avoiding
•
reducing
•
insuring
•
sharing
•
subcontracting
•
further researching of
... the risk concerned
Evaluating cashflows
A distribution of NPVs for the project can be created by either creating a number of
deterministic scenarios based on the occurrence of certain risk events or using a
stochastic modelling approach. This stage of the project will be iterative with the risk
identification, analysis and mitigation stages.
In order to calculate the NPV of the project, we need to choose a suitable risk discount
rate.
If the project is considered to have a normal degree of systematic risk, then the risk
discount rate is typically based on the sponsoring company’s optimum weighted
average cost of capital (WACC).
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 information is not available, the risk discount
rate may be set by applying an arbitrary addition to the optimum WACC above.
Investment decision
The final investment decision wm reflect both the distribution of NPVs - perhaps
calculated by means of a stochastic model - and the characteristics of the residual risks
that cannot be mitigated. Particular attention will be paid 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 a document caned the
investment submission.
Chapter 14 Summary - Cashflows of simple products
Cashflow matching and process
Cashflows are simply sums of money that are paid or received at particular times.
A cashflow projection sets out the expected payments and receipts under a contract.
The provider of a financial product will usually aim to match expected payments and
receipts. This is not a trivial exercise because the amounts and timings of the cashflows
relating to both the payments and the receipts may be uncertain.
Where there is uncertainty about the amount or timing of cashflows, an actuary can
assign probabilities to both the amount and the existence of a cashflow.
Alternatively, the provider may decide not to match expected payments and receipts but
instead hold additional capital to cover the risk that the assets are insufficient to cover,
the liabilities.
Cashflows of simple financial products
The two tables below summarise the payments and receipts of the financial products
covered in this chapter, from the perspective of the provider, eg an insurance company.
These could be reversed to give the perspective of the customer.
Payments (from the provider)
Contract
Payments
Timing of
Amount of
payments known in payments known
advance?
in advance?
Immediate annuity
Regular annuity
payments
Yes if level or fixed Yes but unknown
number of
increases
payments
No if index-linked
increases
Term assurance
Lump sum on
death
Yes unless sum
assured is indexed
No
Endowment assurance
Lump sum on
maturity or on
earlier death
May be known if
without-profit
unknown if unitlinked and part
known/unknown if
with-profit
No
Optional lump
sum on
discontinuance
Discontinuance
payment unknown
Interest-only loan
Loan amount
N/A
N/A
Repayment loan
Loan amount
N/A
N/A
Motor insurance policy
Claim amounts
No as depends on
extent of claim
No as depends on
when claim
occurs, is reported
and on length of
claim settlement
In addition to the main payment(s) detailed in the table above, the provider will incur
additional payments in the form of expenses in relation to each of the above contracts.
The amount and timing of the expenses will depend on the nature of the expenses and
may or may not be known.
Receipts (to the provider)
Contract
Receipts
Timing of receipts
Amount of
receipts known in known in advance?
advance?
Immediate annuity
Single premium
N/A
Term assurance
Regular premiums Yes unless
or single premium premiums are
indexed
Yes but unknown
number of payments
due to death
Endowment assurance
Regular premiums Yes unless
or single premium premiums are
indexed
Yes but unknown
number of payments
due to death or
discontinuance
Interest-only loan
Regular interest
repayments
followed by a
return of the initial
loan amount
Yes if interest rate Yes unless repaid
early
fixed
Regular interest
and capital
repayments
Yes if interest rate Yes unless repaid
early
fixed
Repayment loan
N/A
No if interest rate
variable
No if interest rate
variable
Motor insurance policy
Single annual
premium or
regular premiums
throughout the
year
Yes unless policy
discontinued or
endorsements
made
Yes unless policy
discontinued or
endorsements made
For those contracts above where premiums are payable, there may be additional
receipts to the provider in the form of investment income earned on the premiums
received. Such income will be most significant for the immediate annuity and
endowment assurance and least significant for the motor insurance policy. The amount
and timing of the investment income will depend upon the characteristics of the assets
purchased and mayor may not be known.
Chapter 15 Summary - Money markets
Features of money market investments
Institutional investors can make short-term investments in the money market by lending
to government bodies, banks and companies.
Money market investments have the following key features:
•
security depends on issuer
•
all return is through income (or capital gain that can be considered as income)
•
level of income has a loose, indirect link with inflation
•
lower expected returns than equities or bonds over the long term
•
stable market values
•
short term
•
minimal dealing expenses
•
normally highly marketable
•
return normally taxed as income
Cash deposits
Clearing banks dominate the market in short-term deposits. They issue call deposits,
term deposits and certificates of deposit. Interest rates may be fixed or variable over the
term of investment.
Attractions of cash investments
Institutions may hold a portion of their funds in very liquid money market investments
for the following possible reasons:
•
to meet short-term commitments
•
to be ready to take advantage of other investment opportunities because outgo is
uncertain, so some funds need to be kept liquid
•
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
A larger holding of money market investments may be justified if the institution is
pessimistic about the outlook for other investment categories, eg if it expects:
•
rising interest rates (which might cause other asset values 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
Chapter 16 Summary - Bond markets
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
•
Eurobond markets
Other important bond markets include bonds issued by regional governments and
foreign bonds, which are issued outside of the borrower’s country in the currency of the
country where they are issued.
.
The main difference between government bonds and other debt securities is that the
latter are generally both less secure and less marketable than government bonds –
consequently, investors will generally require a higher yield in order to hold them.
Yield curve
The yield curve is a plot of gross redemption yields against term to redemption. Several
theories have been put forward to try and explain the shape of the yield curve:
•
expectations theory - yields reflect future short-term interest rates
•
liquidity preference - investors require an additional yield on less liquid stocks
•
inflation risk premium - investors require yields to incorporate an inflation risk
premium
•
market segmentation - yields at each term are determined by supply and demand
from investors with liabilities of that term
The real yield curve is a plot of real gross redemption yields on index-linked bonds
against term to maturity. The difference between the conventional yield curve and the
real yield curve is approximately the markets expectations of future inflation.
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.
Chapter 17 Summary - Equity markets
Characteristics of equities
The main features of equity investment are:
•
uncertainty: neither income nor capital values are guaranteed low and hopefully
increasing, income stream
•
usually a long term investment historically
•
good long term returns
•
good long term protection against inflation
•
volatile market values
Market values for equities are set by supply and demand and these are dependent on the
markets expectations. Views and expectations of investors change regularly and this
generates the price volatility for equities.
Investors generally expect share prices to rise with inflation and economic growth in
the long term. These expected price rises explain why investors will accept a low initial
income yield from equities.
A well-diversified portfolio will help protect investors from the occasional disastrous
company, but it wm not protect against a fall in the whole market.
The marketability of shares varies a lot between companies. It is much better for large
companies.
Most equity investment is in quoted shares that are listed on a stock exchange. In order
to obtain a listing companies have to comply with the stock exchange’s regulations,
which give investors a measure of protection.
Dealing systems
The two main types of dealing systems are the:
1. quote driven system - under which market makers quote both buying and selling
prices at which they are prepared to deal
2. order driven system - whereby buyers and sellers post bids that are matched,
usually electronically
Why use industry groupings to categorise shares?
Shares are grouped by industry sectors because:
•
It is more practical for analysts to specialise in one area.
•
The share prices and the profitability of companies in the same sector are
correlated.
Preference shares
Preference shareholders have priority for payment of dividends and (usually) return of
capital over ordinary shareholders.
Chapter 18 Summary - Property markets
Definition of property expressions
Prime property scores highly on all of the following factors:
•
location
•
age and condition
•
quality of tenant
•
the number of comparable properties
•
lease structure
•
size
The running or rental yield on a property is a running yield based on rent ÷ value.
Characteristics of direct property investment include:
•
long-term real returns
•
stepped income stream
•
running yield between that on equities and conventional bonds
•
unmarketable
•
high dealing and management costs
•
void probabilities
•
long-term volatility of capital values but short-term stability due to infrequent
valuations
•
susceptible to political risk
•
expected return higher than that on index-linked government bonds
•
large unit size
•
indivisibility
•
uniqueness
•
subjective valuations
•
obsolescence, deterioration and refurbishment costs
•
possibility for investment characteristics to be changed by the investor, eg
redevelopment
•
can provide high utility (feel good factor) to the investor
Indirect property investments
Indirect investments in property share companies and pooled property funds are
available. They help overcome some of the key problems with direct property
investment (eg lack of marketability and large indivisible units). However, they are not
without their own problems. Key issues to consider when comparing direct and indirect
property investments include:
•
control
•
correlation with equities discount to NAV
•
diversification
•
divisibility
•
expenses
•
expertise
•
exposure to other sectors
•
forced sales
•
gearing
•
marketability
•
taxation
•
valuation
•
volatility
Freehold and leasehold
The freeholder of property is the absolute owner of it in perpetuity. A leaseholder has
use of a specified portion of a building for a specified period (as set out in the lease
agreement) in return for some payment.
Compared with freehold investment, a leasehold is shorter-term and provides a higher
initial rental yield and a capital loss.
Property sectors
The different sectors or property investment all respond to economic growth, but are
influenced by different elements of the economy:
•
offices - businesses in general, but particularly the service sector
•
shops - consumer expenditure
•
industrial - manufacturing industry
The rental yields available from different sectors reflect their popularity with investors
and the extent to which future rental growth is expected. Prime shops generally have
the lowest rental yields, followed closely by offices. The rental yields on industrial
properties are higher reflecting lower prospects for growth, poorer marketability, higher
expenses and more rapid depreciation.
Offices tend to be popular with institutional investors, relative to other sectors because
of their large unit size, wide range of prospective tenants, propensity to be multi-let,
relatively low expenses and secure rental income (compared with other sectors).
Chapter 19 Summary - Futures and options
A derivative is a financial instrument with a value dependent on the value of some
other, underlying asset.
A futures contract is a standardised, exchange-tradable contract between two parties to
trade a specified asset on a set date in the future at a specified price.
A forward contract is a non-standardised, over-the-counter-traded contract between
two parties to trade a specified asset on a set date in the future at a specified price.
An option gives an 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.
An American option is an option that can be exercised on any date before its expiry.
A European option is an option that can only be exercised at expiry.
A warrant is an option issued by a company. The holder has the right to purchase
shares at a specified price at specified times in the future.
A long position in an asset means having a positive economic exposure to that asset. In
futures and forwards dealing, the long party is the one who has contracted to take
delivery of the asset in the future.
A short Position in an asset means having a negative economic exposure to that asset.
In futures and forwards dealing, the short party is the one who has contracted to deliver
the asset in the future.
Chapter 20 Summary - Collective investment vehicles
Collective investment vehicles provide the opportunity for investors to achieve a wide
spread of investments, whilst benefiting from specialist management expertise.
There are two fundamental types of collective investment vehicles - closed-ended and
open-ended. In a closed-ended vehicle, such as an investment trust company (ITC),
once the initial tranche of money has been invested the fund is closed to new money. In
contrast, in an open-ended vehicle such as a unit trust (UT), managers can create or
cancel units in the fund as new money is invested or disinvested.
An open-ended investment company (OEIC) is an investment vehicle that is a cross
between and investment trust company and a unit trust.
When considering the merits of investing in collective investment vehicles, the
institutional investor should consider:
+ extra diversification
+ expertise and specialisation provided
+ savings on administration
+ divisibility
+ benefits of having some gearing (investment trust companies only)
+ any gain in marketability on the underlying shares (unit trusts only)
+ possible narrowing in the discount to NAV (investment trust companies only)
+ possible tax advantages
+ potential to track a specific index
–
loss of direct investment control
–
management charges
–
extra risk/volatility caused by gearing and discount to NAV (investment trust
companies only)
–
possible widening in the discount to NAV (investment trust companies only)
–
possible tax disadvantages
Similar considerations apply for unit trusts, except:
•
no discounts to NAV
•
no gearing
•
usually higher charges
•
taxation and marketability conditions differ slightly
Chapter 21 Summary - Overseas markets
Why invest overseas?
Overseas investment is helpful in improving the risk/reward relationship for the
investor.
Risk is reduced by:
•
matching liabilities (if applicable)
•
diversifying (ie reducing correlation with the returns from domestic assets)
Returns can be enhanced by investing in:
•
Strengthening currencies
•
fast-growing economies (if the expectation of fast future growth is not reflected
in the price already)
•
undervalued markets
Overseas investment has some potential drawbacks:
•
liabilities may be mismatched
•
currency movements cause additional volatility
•
political risks (eg confiscation of assets)
•
possible tax inefficiencies
•
poorly regulated markets
•
poor marketability
•
lack of quality information on shares
•
different accounting methods/standards
•
possible time delays
•
language problems
•
restrictions on ownership of certain shares by foreign investors
•
problems repatriating funds
•
possible lack of liquidity
•
additional dealing and management expenses
•
additional administration
What to invest in overseas
Most of the main asset categories are available in many countries, although indirect
investment is a useful medium, especially for:
•
small investors
•
investors looking for exposure to specialist niche markets
The usual arguments for and against collective investment vehicles are relevant for
overseas investments.
Emerging markets
Emerging markets can be very volatile, and this gives investors the chance of making
very big gains (or very big losses).
All of the advantages and disadvantages of overseas investment are particularly
relevant for investing in emerging markets.
Chapter 22 Summary - Economic influences on
investment markets
Interest rates
Short-term interest rates are determined largely by government policy, as the
government balances the need to control inflation against the need to encourage
economic growth. They may also be used to manage the level of the exchange rate. The
level of interest rates is usually a little above the rate of inflation.
Long-term interest rates are determined mainly by expectations of future short-term
interest rates and hence inflation.
Bond yields
The main factors affecting the level of bond yields include:
•
inflation
•
short-term interest rates
•
the fiscal deficit
•
the exchange rate
•
institutional cashflow
•
returns on alternative investments, both domestic and overseas
The level of the equity market
The most important determinants of the general level of the equity market 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
Other factors influencing the level of the equity market include:
•
the exchange rate
•
the attractiveness of alternative investments
•
the overseas market
•
supply-side factors
•
institutional cashflow
•
taxation
•
the political climate
The level of the property market
Economic factors can affect:
•
occupational demand
•
investment demand
•
supply from the development cycle
Economic factors have a big impact on the properly market. The key factors are:
•
economic growth
•
real interest rates
Inflation, exchange rates and institutional cashflow 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:
•
planning permission rules and the limited physical space in some areas
•
the time required to develop new properties
•
fixity of location
•
high transaction costs
•
segmented markets
Chapter 23 Summary - Investment indices
An investment index represents the relative changes in the share/stock prices or yields
of the constituent companies or stocks which make up the index.
Uses of indices
Appropriate indices can be used:
•
as a measure of short-term market movements
•
to provide a history of market movements and levels
•
as a tool for estimating future movements in the market
•
as a benchmark for performance measurement
•
for valuing a notional portfolio
•
in analysing sub-sectors of the market
•
as a basis for index funds which track the particular market
•
to provide the basis for the creation of derivative instruments
In particular, government bond yield indices can also be used:
•
as a standard against which to assess yields on other fixed-interest investments
•
to approximately value a fixed-interest portfolio
•
to provide a picture of general yield structures of fixed-interest investments
•
as a measure of the yield gap with equity dividend yields
FTSE Actuaries share indices
The FTSE 100 Share index is based on the 100 largest companies in the UK equity
market. It is calculated on a real-time basis and is the most widely quoted of the UK
Series of the FTSE Actuaries Share Indices.
The FTSE Actuaries All-Share Index covers about 98% of the UK equity market by
value and is calculated daily.
Other UK FTSE Actuaries indices include the FTSE 250, the FTSE 350 and the FTSE
SmallCap.
FTSE Government securities UK indices
The FTSE Actuaries Government Securities Index includes price and yield indices.
Conventional gilts and index-linked gilts are treated separately.
International equity indices
The FTSE World Indices provide a comprehensive basis for assessing the performance
of international funds. The indices are made up from indices of equity prices in
different countries and indices are also maintained for various geographical regions.
The Morgan Stanley Capital International Indices are also widely used.
The Dow Jones Industrial Average is an index of thirty leading New York shares.
Although widely quoted, it is not suitable for performance measurement. The Standard
& Poor’s 500 Index is more suitable for this purpose.
A commonly quoted Japanese index is the Nikkei Dow Industrial Average 225.
The performance of major European companies can be measured by the FTSE Eurotop
indices, their Eurobloc equivalents and the Dow Jones Eurostoxx 50.
Property indices
Property price indices are very difficult to maintain because:
•
there is little reliable, up-to-date price data for properties at anyone moment
•
properties tend to be very heterogeneous
Chapter 24 Summary - Other factors affecting relative
valuation
An increase/decrease in the demand for an asset will lead to upward/downward
pressure on the price of the asset.
Demand for an asset will change if either:
•
investors’ opinions of the properties of the asset remain unchanged but external
factors alter the demand for that asset. These external factors include investors’
incomes, investors’ preferences and the price of other investment assets.
•
investors’ perceptions of the characteristics of the asset, principally risk and
expected return, alter.
An increase/decrease in the supply of an asset will lead to downward/upward pressure
on the price of the asset. The supply of a financial asset will be increased by new issues
of that asset and decreased by redemptions.
Supply may also be increased by technological innovation.
The impact of changes in demand and supply upon the price of an asset will depend
upon the availability or otherwise of close substitutes that investors may purchase
instead.
Chapter 25 Summary - Relationship between returns on
asset classes
The return that investors, as a whole, require on any asset class can be written as:
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
where capital growth occurs either due to:
•
income growth, or
•
a change in the initial income yield
If assets are fairly-priced, required and expected returns 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.
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.
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.
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.
Chapter 26 Summary - Economic modelling
Economic asset models
There are now a large number of stochastic asset models in existence, both in the public
and private domains. They use Monte Carlo simulation techniques to generate the
distributions of key outputs such as:
•
inflation
•
real and nominal interest rates
•
dividends
•
dividend yields
•
equity prices
Asset modelling requires a balance to be struck between realism and simplicity. A set
of attributes for a “good” model includes:
•
Representativeness - the model mimics the behaviour of real-world financial
assets.
•
Economic interpretation - the behaviour of assets within the model should be
consistent with generally accepted economic principles. In particular, we would
expect the generated results to be arbitrage-free.
•
Parsimony - models should be as simple as possible, while retaining the most
important features of the problem.
•
Transparency - the workings of the basic model should be easy to appreciate
and communicate.
•
Evolution - the model should be capable of development and refinement.
•
Implementation tools - a range of methods of implementation should be
available to facilitate testing, parameterisation and focus of results. These might
include analytical calculations, historical back-tests, scenario analysis, treebuilding techniques and Monte Carlo simulation.
Outputs
Most stochastic asset models:
•
generate price indices to produce inflation projections
•
generate projected equity dividends and dividend yields from which to derive
equity price indices and total returns
•
project long-term interest rates (consol yields) and short-term interest rates
(base rates). A full yield curve can then be derived from these two, together with
the returns on bonds.
•
use a more simplistic approach for real (index-linked) yields
Internal structures
The typical model will involve five or six innovation “drivers” to generate the
stochastic features. It will require about 40 to 50 parameter values to be estimated and
15 initial conditions to be specified in order to generate a projection sequence.
Consideration must also be given to the:
•
range of variable values to be generated
•
nature of equity returns; and in particular whether they are negatively skewed,
have “fat” tails and have a varying volatility - which can be modelled using a
Markov regime-switching model
•
mean reversion of dividend yields.
Comparison between models
When comparing the results generated by different models, it is important to consider
the development in projections of:
•
the median (or mean) values of the output variables
•
the standard deviations of the output variables
•
the correlation coefficients between variables
The results generated should be consistent with both an economic interpretation and
historical results.
Chapter 27 Summary - Meeting investor needs institutions
Actuarial risk
Actuarial risk is defined to be the risk of failing to meet the investment objectives of the
investor. In practice it is often interpreted as the measure of uncertainty of return
relative to the liabilities. By contrast, in most investment theory, risk is defined as the
variability of nominal investment return.
The liabilities
The main features of liabilities that will influence investment strategy are:
•
nature - ie whether or not they are subject to inflationary increases
•
term
•
currency
•
degree of uncertainty in timing and amounts.
In some cases a fund may have both a realistic value and a statutory value of liabilities.
In this case the approach should be to meet the ongoing liabilities as well as possible,
subject to this being acceptable in terms of the statutory valuation of liabilities.
Factors influencing investment strategy
Other key factors that influence investment strategy are:
•
tax (both the treatment of the asset and of the investor)
•
statutory, legal or voluntary restrictions on how the fund may invest
•
the 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
•
future liabilities
•
the existing portfolio
•
the strategy followed by other funds
•
the investor’s attitude to risk
•
the investor’s objectives
Income, growth, volatility and tax
Investors’ preferences for income or capital growth from their investments are
governed by two main factors: tax and cashflow requirements.
For Some long-term institutional investors, fluctuations in asset values are not of much
concern. However, they may be important for institutions that are required to
demonstrate solvency on a regular basis and have a low level of free reserves.
Tactical asset allocation
Tactical asset allocation involves a departure from the benchmark position in an
attempt to maximise return. This may conflict with the minimisation of risk.
Factors to be considered before making a tactical asset switch are:
•
the level of the free reserves
•
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
Individual investments
When selecting individual investments, the important factor for an institution is the
effect that the investment win have on the performance and the diversification of the
total portfolio.
Active and passive investment management
Passive - this involves holding assets closely reflecting those underlying an index or
specified benchmark. The investment manager has little freedom of choice. There
remains the risk of tracking errors occurring and the possibility of a poorly performing
index or benchmark.
Active - a method where the 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.
Chapter 28 Summary - Personal investment
Strategy
The main factors an individual should consider in making investment decisions are:
•
having sufficient liquid assets to meet fluctuations in day-to-day expenditure
•
having adequate insurance so that emergency funds don’t need to be too big
•
the period when asset proceeds are required, ie when total expenditure exceeds’
other income
•
that usually liabilities are predominantly real and domestic, so real, domestic
assets are preferable
•
the existence or excess assets, as these afford investment freedom
•
the best value investments are probably those that have specific tax advantages
•
there should be adequate diversification overall
•
their own risk appetite.
Other relevant factors are:
•
likely lack of investment expertise and information compared with professional
investors
•
the relatively high expenses incurred when investing small amounts
•
stability of values should not be a major factor for long-term investment
•
short time horizons for many individuals make stability of asset values seem
important
Income, gain, volatility and tax
The taxation basis for individuals on investment returns will often make capital gains
preferable to investment income, particularly for wealthier individuals.
If there are tax-efficient savings vehicles available to individual investors then, in
general the individual investor should probably make maximum use of these schemes
before making long-term direct investments in the underlying assets (ie equities, bonds,
etc). The amounts allowed within these schemes may be sufficiently high that only
wealthy investors will use up their allowances in each vehicle.
Collective investments
The advantages of collective investment vehicles are:
•
relative ease of investment
•
investment expertise provided
•
appropriate for small sums
•
automatic diversification
•
possibility of more stable (smoothed) investment returns (eg with-profit
policies)
•
possibility or guarantees (eg with-profit policies)
•
possible availability of tax advantages
The possible disadvantages are:
•
relatively high expense levels
•
the asset mix might not be appropriate
•
the basis for saving may be inflexible
For most individual investors, the advantages will outweigh the disadvantages.
Chapter 29
investments
Summary
-
Valuation
of
individual
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. Many
of the methods used by actuaries are based upon discounted cashflow techniques.
Market values vs calculated values
Market values have a number or advantages and disadvantages. Using a value other
than market value implies taking 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.
Bond valuation
Bonds are valued by calculating the discounted value of the constituent cashflows. The
discount factor used to value each payment should be based upon the spot interest rate
of the appropriate term, adjusted to reflect the riskiness of the payment and the
marketability of the particular bond.
Equity valuation
The discounted dividend model derives the value of a share as the discounted value of
the estimated future dividend stream. Under certain assumptions, the price of a share
should be:
D
i−g
The definitions and assumptions underlying this discounted dividend model are:
•
D is the dividend one year away, dividends paid annually thereafter
•
i is the required rate of return (including risk margin)
•
g is the constant annual growth in dividends.
The valuation formula can be modified for any changes in the assumptions.
Other equity valuation methods include net asset value, value added methods and the
use of measurable key factors of a company’s business.
Chapter 30 Summary - Valuation of asset classes and
portfolios
Analysis of expected returns from different assets
Cheap and dear investment sectors can be identified by comparing expected returns
from the assets with the returns required to invest in the category. Assets should be
considered cheap if the expected returns exceed the required returns.
The expected return will be from the expected income and the expected capital gain.
We will need various assumptions about the future to determine this for most asset
categories.
The required return should be the sum of three components:
•
the required risk-free real rate of return
•
the expected rate of inflation
•
the risk premium required for the particular asset category
By using this approach, we can analyse the relative cheapness or dearness of the main
asset categories by comparing their yields, and hence comparing expected growth rates
and risk premiums.
The yield gap is defined as the gross dividend yield on equities less the gross
redemption yield on long dated government bonds. It reflects the relative level of prices
of equities compared with bonds. However, its use must be tempered by several factors,
most notably changes in expected inflation.
The reverse yield gap is the other way round, redemption yield less dividend yield.
The real yield gap shows the relative prices of equities against index-linked government
bonds. It is the gross dividend yield less the real yield from long dated index-linked
government bonds. Unlike the yield gap, its relationship is not disturbed by changing
levels of expected future inflation.
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.
Chapter 31 Summary - Developing an investment
strategy
Matching fixed liabilities
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.
Fixed monetary liabilities can be matched by fixed monetary assets provided that:
•
the timing and amounts for both assets and liabilities are certain
•
assets of long enough term exist
•
asset proceeds do not exceed liability outgo in the early years
Asset-liability modelling
The appropriateness of an investment strategy can be assessed by using deterministic
and stochastic models of asset proceeds and liability outgo.
A deterministic model is based on a set of specific assumptions about the future. It is
simpler, and can be used to check the term of the assets compared with the term of the
liabilities. Scenario modelling is then required to test whether the assets are of the right
type.
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.
The models should help show the level of mismatching risk that is possible, without
prejudicing the solvency of the fund.
Other techniques
Other techniques for determining an investment strategy are:
•
mean variance optimisation without reference to the liabilities
•
basing asset allocations on market capitalisations
•
shadowing the strategies of other comparable institutional investors
Chapter 32 Summary - Credit risk and credit ratings
Considerations when lending
When lending to a counterparty there are many aspects to consider, the most important
being:
•
the character and ability of the borrower
•
that there is a valid purpose for the loan
•
that the amount that is being borrowed is reasonable given the purpose
•
that the lender has the ability to repay
•
that security is given to reduce the risk
•
the risk versus reward trade off
When security is taken as collateral for a loan it is important that:
•
the pledge is enforceable in law
•
the security can be registered before the loan is completed
•
any documents are stored safely and easily referenced
Managing a debt portfolio
The principal credit-related risks associated with a portfolio of debt securities are:
•
counterparty risk (leading to replacement risk)
•
settlement risk (also sometimes referred to as credit risk) at the point the
settlement occurs
•
liquidity risk
•
concentration risk
Credit risk is also more generically used to define the following types of risk event:
•
changes in credit quality
•
variation in credit spreads
•
default events
Credit ratings give an indication of the likelihood of default.
Chapter 33 Summary - Capital
Why providers need capital
Economic capital is the amount of capital that a provider determines it is appropriate to
hold given its assets, its liabilities, and its business objectives. Regulatory capital is
required to protect against the risk of statutory insolvency.
Types of capital can be split into three broad groups:
•
equity
•
debt
•
hybrid
As well as the usual capital needs of any business, providers need capital for various
specific aspects of their business:
•
achieving overall strategic direction (eg acquisitions and new ventures)
•
smoothing accounts and improving the solvency position of the balance sheet
•
funding the cashflow strain of new business caused by the timing mismatch of
expenses and charges
•
enabling the provider to offer products with guarantees
•
following a less constrained investment strategy
•
attracting new business
Sources of capital
The State does not have the same capital needs as other providers as it can usually raise
funds to meet its liabilities through taxation, borrowing or printing money.
All companies can increase their working capital by retaining profits or surpluses
within the business and not distributing them as dividends or bonuses.
A proprietary insurer is an insurance company owned by shareholders. A propriety
company may raise funds through the issue of shares or debt securities.
A mutual insurer is one owned by policyholders to whom all profits (ultimately)
belong. A mutual company has less access to the capital markets than a proprietary.
Reinsurance can be used both to reduce the amount of capital required and also as a
source of capital. Reinsurance is available to both mutual and proprietary companies.
Regulatory environment
There is likely to be regulation concerning the calculation of provisions in respect of
future liabilities.
Given that the future is difficult to predict, the assumptions used to calculate these
provisions will contain margins above those which might be assumed on a best estimate
basis, ie they will be prudent.
As a further cushioning against the future uncertainty, the regulator will generally
require that the insurer holds further “free” capital as a buffer for general adverse
experience. Such capital is termed the minimum solvency requirement or margin.
Chapter 34 Summary - Introduction to contract design
Factors to consider in designing a contract
In determining a suitable design for any financial contract, the following factors should
be considered:
•
the characteristics of the parties involved
•
the level and form or benefits to be provided
•
any options or guarantees that may be included
•
the method of financing the benefits to be provided
•
the choice of assets when benefits are funded
•
the charges that will be levied
•
the capital requirements
Parties involved
The parties involved in a contract design include:
•
the client or clients
•
the client’s or clients’ customers
•
actuaries
•
lawyers and compliance officers
•
accountants
•
financial backers
•
administrators
•
sales and marketing employees
•
computer programmers and systems analysts
Clients’ and customers’ needs will also be influenced by:
•
capital/capacity to pay
•
expertise/financial sophistication
•
the risks to be covered and benefits needed
•
attitude to risk
•
the chosen market
Level and form of benefits
The level and form of benefits to be provided may vary according to the:
•
client’s needs
•
risks to be covered
•
client’s ability to pay
Options and guarantees
Options and guarantees must be charged for within the financial contract. Typically this
will be as an up-front addition to the premiums paid. However, sometimes it can take
the form of a reduction in benefits paid.
Method of financing
There are two key methods of financing benefits - pay-as-you-go and funding.
Funding can take the form of:
•
a lump-sum payment in advance
•
regular contributions in advance
•
an amount set aside when the benefit event first happens
Choice of assets
In choosing assets in which to invest the fund, the key considerations are:
•
the match by nature, timing and predictability of the liabilities
•
the overall return (net of tax and expenses) and the opportunity cost of funding
•
the risk attitude of the customers/clients
•
liquidity
•
government regulation and incentives
•
diversification
Charges
The charges will need to meet the expenses incurred by the provider in setting up and
managing the contract.
Capital requirements
The capital requirements will depend on the riskiness of the benefits promised.
Characteristics of a good product design
A good design for a product requires that the product:
•
is simple to understand and simple to administer
•
is transparent in its structure and charges
•
provides benefits that demonstrably meet the identified needs of the
client/customer
•
has a large enough market and is competitive
•
is profitable
•
is capital efficient
•
provides benefits on discontinuance, which are fair
Discontinuance terms
The overriding principle in determining discontinuance terms is that they are fair to:
•
the policyholder or scheme member
•
other policyholders and scheme members
•
the provider of the benefits
Factors for the provider to consider in relation to discontinuance are the:
•
contracts for which to offer discontinuance terms (as determined by market
practice, regulation or complexity in calculating terms)
•
costs of determining and implementing discontinuance terms
•
form of the discontinuance terms offered (eg lump sum or paid up value)
Discontinuance terms -life insurance
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 expectations
•
new business disclosure and competitive considerations
•
frequency of change of discontinuance terms
•
case of application of discontinuance terms
Discontinuance terms - 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 vested rights within a scheme.
At the time of discontinuance, the scheme may be under-funded and the benefits
provided on discontinuance may need to be reduced to reflect this. If the whole scheme
is discontinued, consideration will need to be given to the priority of the different
groups of members of the scheme in receiving benefits.
At the time of discontinuance of scheme benefits the scheme may be over-funded and
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.
Flexible benefits systems
Organisations can tailor the benefits offered to employees using a flexible benefits
system. Under 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.
These circumstances may change over time.
Employers use flexible benefit schemes to attract, motivate and retain staff.
Chapter 35
management
Summary
-
Introduction
to
risk
The risk management process
Risk management can be described as the process of ensuring that the risks to which an
organisation is exposed are the risks to which it thinks it is exposed and to which it is
prepared to be exposed.
The aim of risk management is to protect an organisation against experience that could
result in it being unable to meet its liabilities.
The risk management process consists of risk:
•
identification
•
measurement/assessment/impact
•
control
•
financing
•
monitoring
Risk control is the implementation of systems that aim to:
•
avoid the financial consequences of a risk
•
limit the severity of a risk that does occur
•
reduce the consequences of a risk that does occur
Risk control measures should give a measurable reduction in the total cost of the risk.
The total cost of a risk = loss control + insurance + self-insurance.
Types of risk
The major types of risk faced by a financial organisation are:
•
credit risk - risk of default by third parties
•
market risk - risk of price volatility
•
operational risk - risk of inadequate or failed internal processes, people or
systems, or external events, or the dominance of a single individual over the
running of a business.
Risk classification
Risk classification is a tool for analysing a portfolio or risks by the risk characteristics,
such that each subgroup of risks represents a homogeneous body of risk. Risk
classification helps the provider charge a more accurate premium for the risks to be
covered.
The provider needs to decide upon which risks to:
•
reject/avoid
•
retain/accept
•
transfer (insure or subcontract)
•
share
•
minimise
Retained risks may necessitate a change in contract design. The extent of risk transfer
will depend on the:
•
probability of the risk occurring
•
severity of the risk and the resources that the provider has to meet the cost
•
cost of transferring the risk and willingness of a third party to accept the risk
Risk as an opportunity - alternative risk transfer
The idea behind insurance is that risk is an opportunity. In recent years, alternatives to
traditional insurance have emerged. This market is called alternative risk transfer
(ART).
ART contracts include:
•
discounted covers
•
integrated risk covers
•
securitisation (eg catastrophe bonds)
•
post loss funding
•
insurance derivatives
•
swaps
Financial providers may see ART contracts as providing more effective risk
management. Reasons why providers take out ART contacts 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 or risk management
•
as a source of capital
Chapter 36 Summary - Valuations - valuing benefits
Reasons for differences in method and assumptions
A best estimate basis is a basis with an equal probability of overstating or understating
values.
The strength of the basis used depends upon:
•
the reason for the valuation
•
the needs of the client
•
regulation
Best estimate assumptions vary from scheme to scheme because of the:
•
nature of the benefits
•
types of the assets held
•
features of the beneficiaries
•
other characteristics of the scheme
Factors affecting the strength of the basis
•
Decisions by regulators - assumptions may be dictated by legislation or left to
actuarial judgment but with requirements for disclosure.
•
Decisions by beneficiaries - consider assumptions that take into account the
individual beneficiary’s circumstances - usually realistic, but also consider a
range of different assumptions to communicate the risks of over- or under-contributing.
•
Provisioning - consider a cautious approach to safeguard the security of benefits
but not so cautious that the cost to the provider becomes so onerous that the
provider risks failure.
•
Decisions relating to investments - consider a range of different assumptions
and stochastic modelling.
•
Decisions by shareholders - decisions are made based on company accounting
information - consider realistic assumptions or slightly prudent assumptions if
accounting standards dictate this.
Liability transfers
In relation to liability transfers, assumptions may be set by the:
•
actuaries of both providers in a provider to provider transfer
•
provider and/or legislation in a provider to individual or in an individual to
individual transfer
Setting future assumptions can be difficult if the likely future experience would be
different for the two parties.
Approaches to caution
A basis can be made more cautious by:
•
having an explicit contingency loading
•
introducing margins in the assumptions
Chapter 37 Summary - Valuations - setting the discount
rate
Approaches to valuing assets and liabilities
Traditional discounted cashflow approach: long-term discount rate used to value assets
and liabilities.
Market value approaches: assets are valued at market value, and therefore need to value
liabilities using a market-related approach too in order to achieve consistency.
The pure application of financial economics can be used to find the market price of the
liabilities, but it is difficult to achieve in practice.
Setting the discount rate
Method
Valuation of assets
Valuation of liabilities
Discounted cashflow
Long-term rate based on Same long-term rate as
actual holding or notional assets
portfolio
Variation on discounted Market value
cashflow
Long-term rate then result
is multiplied by MVA
Asset-based
Market value
Rate implied by market
price of actual holding or
notional portfolio
Replicating portfolio (mark Market value
to market)
Rate implied by market
price of investments that
match liabilities - often
bonds
Replicating portfolio (bond Market value
yields plus risk premium)
Rate as in mark to market
method, but then adjusted
to take account of higher
expected returns on other
asset classes
Fair value reporting
In recent years there has been an increasing move towards such methods.
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.
This is usually achieved by starting with the risk-free rate, then adjusting for:
•
financial risk
•
mismatching risk
•
non-financial risks:
-
demographic expense
-
persistency compliance
-
other operational risks.
Chapter 38 Summary - Input validation
Data requirements
The main uses of data are:
•
administration
•
accounting
•
statutory returns
•
investment
•
financial control, management information
•
risk management
•
setting provisions
•
experience statistics
•
experience analyses
•
premium rating, product costing, determining contributions
•
marketing
The main sources of data are:
•
publicly available data
•
internal data
Data quality
Poor data can be due to:
•
poor management or verification
•
poor design
A well designed proposal form will be unambiguous to help ensure correct answers are
collected from policyholders.
The information on both the proposal and claim forms must be easy to enter into the
system.
The system must be able to link across proposal and claims records.
Data issues for employee benefit schemes
The information is provided by the sponsor, rather than under the direct control of the
actuary.
Past data can be used to help verify current data.
Accounting data is also useful to help verify cashflows. Asset data will also be checked.
Checks on data
The actuary will make assertions as to the quality of the 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 contribution and benefit levels with the accounts
•
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
Summarised data
Sometimes the actuary only has summarised data. It is not suitable for all valuation
purposes, eg valuing options and guarantees that apply on an individual basis.
Industry-wide data collection schemes
In some countries organisations collect data. Industry data is suitable for setting bases,
but not for valuing an individual policy.
Care needs to be taken as the data can be heterogeneous.
In addition problems arise as the data is less detailed, more out of date, the quality may
be poor and not all organisations will 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.
Chapter 39 Summary - Methodology and techniques
Producing a solution
A model must capture the most important features of the actual situation.
The client must be made award of the uncertainties underlying the model assumptions.
A model can be a:
•
commercially produced product
•
modified existing model
•
new model
Requirements of a good model
A good model will:
•
be valid, rigorous and well documented
•
reflect the risk profile of the business being modeled
•
allow for all the significant features of the business being modeled
•
have appropriate input parameters
•
be communicable and output verifiable and not overly complex
Cashflows
A model needs to allow for all the cashflows that may arise, including:
•
discretionary benefits
•
cashflows arising from any supervisory requirement to hold provisions and a
solvency margin
•
the potential cashflows arising from options and guarantees
It is important that the model is dynamic, ie that it allows for the interaction between
the parameters and variables affecting the cashflows.
The time period between cashflows should be chosen to balance the reliability of the
output with the speed of running the model.
Deterministic cashflow model
The steps involved in running a deterministic model are to:
•
specify the purpose
•
collect, group and modify the data
•
choose the form of model
•
identify the parameters and variables
•
ascribe the parameter values
•
check for goodness of fit
•
fit a new model if the first choice does not fit
•
run the model
Stochastic cashflow model
The steps involved in running a stochastic model are to:
•
specify the purpose
•
collect, group and modify the data
•
choose a suitable density function for each stochastic variable
•
specify the correlations between the variables
•
construct a model
•
check for goodness of fit
•
run the model many times
•
produce a summary of the results
Use of models for pricing - model points
A model point is a representation of a policy. It is usual to identify model points, which
represent relatively homogeneous underlying groups of policies.
Use of models for pricing - the risk discount rate
The risk discount rate is used to discount the future cashflows.
The risk discount rate could allow for:
•
the return required by the company, and
•
the level of statistical risk (assessed analytically or by sensitivity analysis or
from a stochastic model)
Alternatively, a stochastic risk discount rate could be used.
In theory, a different rate could be used for each component of cashflow to allow for
the different levels of risk in each cashflow. However, in practice, a single rate is used
to reflect the average levels of risk.
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(s)
•
profit requirement
•
size of market
•
whether to go ahead with the product
The actuary should also 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 assets and liabilities for regulatory purposes is likely to
be carried out on an individual basis, rather than by using a model.
Use of models for pricing options and guarantees
Options and guarantees are likely to be priced using a stochastic model.
Sensitivity analysis
The results of a model are only as good as the model itself and the choice of the
parameter values.
Sensitivity analysis is used to illustrate the potential variability of the results and to
identify the impact of mis-estimation of the parameter values.
Scenario testing involves changing many parameters in combination.
Goodness of fit tests helps to 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.
Chapter 40 Summary - Assumption setting
Assumptions
All actuarial models need assumptions. The key factors affecting the choice of
assumptions are:
•
the use to which the model will be put
•
the financial significance of the assumption
•
consistency between assumptions
•
legislative and regulatory requirements
Assumptions can be divided into economic and demographic factors.
A collection of assumptions is called a basis. The basis may be optimistic, best
estimate, cautious or prudent, depending on the use to which the model will be put.
Historic and current data
The main sources of data used for determining assumptions are historic and current
data. Sources include national statistics, industry data, actuarial tables and reinsurers’
data.
The 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 from 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 of 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 homogenous 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 views of the company’s
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.
Consistency
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.
Determining assumptions
Demographic assumptions
The actuary will consider the company’s recent mortality, morbidity, critical illness or
long-term care experience (as appropriate) of the contract, or related contracts. This
will allow appropriate adjustment to be made to standard tables. Industry data and
reinsurers’ data may be useful, especially if the company has little relevant data.
Allowance should be made for any expected changes.
The withdrawals assumption will take as a starting point the most recent investigation
for that contract or related contracts, or, in the absence of suitable data, industry
statistics. Some adjustment might be necessary. The commercial and economic
environment is important.
Investment return
This will be set bearing in mind the significance of provisions for the contract, the
extent of investment guarantees, the importance of reinvestment and the intended asset
mix for the contract. The impact of taxation must be considered.
Expenses and commission
Expenses will be loaded for in accordance with the results of the most recent expense
investigation. Some expense modelling work might be entailed for new ventures.
Expense inflation
This will depend on expected future earnings and price inflation. It must be consistent
with the investment return assumption.
Margins
Margins will be necessary to guard against adverse future experience and to allow for
profit. However, competitive pressure forbids too much prudence.
Risk discount rate
The risk discount rate, used to discount the cashflows, will usually be set as the sum of
a risk-free rat of return plus a risk premium.
The following features that can make a contract design riskier, viewed as an
investment:
•
lack of historical data
•
high guarantees
•
policyholder options
•
overhead costs
Profit criterion
A profit criterion is a single figure that summarises the relative efficiency of a contract.
Common profit criteria include NPV, IRR and discounted payback period.
Chapter 41 Summary - Contract design
Contract design factors
In designing or reviewing any contract, the following factors need to be considered:
•
profitability
•
marketability
•
customers’ interests and needs
•
onerousness of any guarantees
•
discretionary benefits
•
competitiveness
•
financing requirement
•
risk characteristics
•
extent of cross-subsidies
•
administration systems
•
consistency with other contracts
•
statutory/regulatory requirements
•
benefits taken early
•
contract conditions
•
accounting implications
•
contribution pattern
Such considerations will need to reflect the nature of the existing contract range and the
distribution channel involved. All other things being equal simplicity in contract design
is preferable to complexity.
These factors are neither independent nor mutually exclusive. Sometimes they will be
conflicting and difficult to resolve.
Considering all eventualities
When designing a contract, the actuary needs to consider the sensitivity of the profits
and the capital requirements of the contract under different eventualities.
Various tools exist to help the actuary in this task. eg stochastic modelling, but
ultimately there is no substitute for experience.
The more extreme scenarios that might be considered usually involve actions by
government or regulators that affect the financial operation of the contract, or that cause
customers to take unexpected actions.
Chapter 42 Summary - Expenses
Types of expenses
Expenses can be split between fixed and variable, and direct and indirect.
Fixed expenses remain relatively constant in the short term. Variable expenses vary by
the 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 in large amounts 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 allocation
Expense allocations take place for many different purposes including pricing,
provisioning, analysis in the accounts and profitability investigations (eg analysis of
surplus).
Expenses need to be allocated by:
•
line of business
•
function (new business, maintenance or termination of business)
Direct salary-related expenses are typically allocated by line of business and function
using staff timesheets.
Indirect expenses (or overheads) can be allocated in several different ways. For
example, premises’ costs can be allocated by floor space occupied by staff and
computing costs using a charge out basis. Other indirect expenses may be excluded
until the end of the allocation and then allocated in proportion to all other expenses.
Expense allocation for premium rating
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.
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 of these
methods.
Chapter 43 Summary - Costing, pricing and funding
Cost vs price
The theoretical cost of benefits is the amount that should theoretically be charged for
them.
The actual cost should be calculated as the value of benefits and expenses plus a
contribution to profit. However, this should then be adjusted to take into account other
factors such as:
•
tax
•
commission
•
cost of capital
•
contingency margins
•
options and guarantees
•
provisioning bases
•
experience rating
•
investment income
•
reinsurance
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
the:
•
distribution channels employed
•
level of competition in the market
•
premium frequency
Once a price has been determined, it should be profit tested and market tested.
For mergers and acquisitions, the price will be affected by factors other than the actual
value of the assets and liabilities being transferred, for example the:
•
relative bargaining power of the parties involved
•
size or the transaction relative to the whole deal
•
supply of parties seeking a merger or takeover and the number of acquirers with
adequate finance in the market
Defined benefit pension schemes - timing of contributions
The main methods of financing benefits are:
•
pay-as-you-go (unfunded)
•
funding
-
lump sum in advance
-
terminal funding
-
regular contributions
-
just-in-time funding
-
smoothed pay-as-you-go
Defined benefit pension schemes - amount of contributions
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 the
pension scheme, or to reflect the sponsor’s desire to pay less or more into the scheme.
Chapter 44 Summary - Provisioning
Provisions
Provisions are amounts set aside to meet future liabilities.
The value placed on the provisions is highly dependent on the assumptions used, which,
in turn, will be highly dependent on the reason(s) for calculating the provisions.
Reasons for calculating provisions
Reasons for calculating 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
Global provisions
As well as calculating provisions in respect of each individual contract, there may be a
requirement to calculate a global provision. The purpose of this global provision may
be to:
•
act as additional protection against insolvency
•
cover risks that cannot necessarily be attributed to individual contracts, eg
mismatching risks, credit risk, market risk, operational risk
•
avoid establishing unnecessarily large individual provisions, eg in the case of
guarantees
The better the provider’s risk management strategy, the greater the justification for
holding lower levels of global provisions.
Assumptions for valuing provisions (published accounts)
The assumptions should have regard to the legislation and accounting principles
governing the preparation of the accounts. 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
Assumptions for valuing provisions (supervisory solvency)
The key features of determining provisions for demonstrating supervisory solvency are:
•
prudence
•
prescription of methods/assumptions by the supervisory authority
When considering the adequacy of the provisions that have been set up for individual
contracts, it is important to do this in the context of the solvency capital requirements.
Assumptions for valuing provisions (internal accounts)
For the purpose of valuing provisions for internal management accounts, a realistic set
of assumptions is typically used.
Assumptions for valuing provisions (merger and acquisition)
The value for merger is based on realistic assumptions without margins and that for
acquisition is based on cautious assumptions that include margins.
Assumptions for valuing provisions (award of discretionary benefits)
Awarding discretionary benefits will dilute the security of the existing benefits
compared with the situation where they are not awarded. Therefore, the assumptions
used in deciding whether or not to award discretionary benefits will err on the side of
caution.
Assumptions for valuing provisions (setting contributions)
The assumptions used will depend on the objectives of the parties concerned. Parties
concerned with the security of the benefits will want to use assumptions that overstate,
rather than understate, the future contribution requirements. Parties that provide the
benefits may not want to unduly tie up capital in the pension scheme, and so may prefer
assumptions that understate, rather than overstate, the future contribution requirements.
Assumptions for valuing provisions (benefit improvements)
Use of the same set of assumptions as used to calculate the cost of the existing benefits
will produce the most realistic indication of the short-term costs that will arise from the
benefit improvements. However, the most realistic indication of the long-term cost will
be based on best estimate assumptions. In practice, the value should be presented on a
range of assumptions to enable a decision to be made.
Assumptions for valuing guarantees and options
In general, when valuing provisions for guarantees and options, a more cautious
approach than normal is taken.
For example, for guarantees, a high probability assumption may be used regarding the
extent to which the guarantee may bite. For options, it could be assumed that the most
beneficial terms are always taken.
The most sophisticated way of valuing provisions for guarantees and options is to use a
stochastic model. However, this is not always the most practical way and deterministic
approaches such as inspection and sensitivity analysis are also used.
The risk of anti-selection must be allowed for when valuing options.
It is important to guard against too much caution because the most beneficial terms to
the customer do not always equate to those assumed by the provider.
Sensitivity testing
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.
Chapter 45 Summary - The relationship between assets
and liabilities (1)
The principles of investment
A provider should select investments that are appropriate to the:
•
nature
•
term, and
•
currency
of the liabilities, and
•
the provider’s appetite for risk
Subject to the above, the investments should be selected to maximise the overall return
(income plus capital) on the assets.
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 paid out
The liability outgo may be split into four categories (see below).
Selecting assets appropriate to the liabilities
•
Liabilities guaranteed in money terms
These consist of the benefit payments specified in money terms less the
premium/contribution income that is fixed in money terms.
Appropriate assets would be those which achieve matching (complete or
approximate) or immunisation.
Any free assets are not likely to be used to support a move away from the
matched position.
•
Liabilities guaranteed in terms of a prices index or similar
These consist of the benefit payments specified by reference to an index, plus
expense outgo, less the premium/contribution income that is linked to an index.
Appropriate assets would be 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 would be real assets 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.
•
Investment-linked benefit payments
Appropriate assets would be those which replicate or are a close approximation
to the index.
Any free assets may be used to maximise returns with any profit benefiting the
provider. However, regulation may disallow mismatching.
Currency
Liabilities denominated in a particular currency should be matched by assets in the
same currency, so as to reduce any currency risk.
Regulation
The regulatory framework within a country may limit what a provider would like to do
in terms of investment. The following controls may be 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 or 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
Matching fixed liabilities
Fixed monetary liabilities can be matched by fixed monetary assets provided that:
•
the timing and amounts for both assets and liabilities are certain
•
assets of long enough term exist
•
asset proceeds do not exceed liability outgo in the early years
Immunisation
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
the rate of interest.
There are a number of theoretical and practical problems with immunisation.
Dynamic liability benchmarks
Dynamic liability benchmarks are benchmarks given to an investment manager that
vary according to the changing nature of the liabilities. Their use reflects an
intermediate position between conventional static benchmarks and full liability
hedging.
Where dynamic liability benchmarks are seen to be necessary, this will influence the
choice of assets - in particular, the liquidity of the chosen assets.
They are often used in respect of currencies.
Chapter 46 Summary - The relationship between assets
and liabilities (2)
Portfolio theory with liabilities
Mean-value portfolio theory can be extended to include an investor’s liabilities as
follows:
S = A∑ xi (1 + Ri ) − L
i
Where
S is the surplus at the end of the period
A is the value of the assets at the start of the period
xi is the proportion invested in security i
Ri is the return on security i
L is the projected value of the liabilities at the end of the period.
Mean-variance portfolio theory can then be applied to minimise the variance of the
surplus for a given expected return.
The need to monitor investment strategy
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
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.
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.
Chapter 47 Summary - Maintaining profitability
Maintaining profitability
There are various ways in which providers can control and manage the cost of the
payments they make and their expenses:
•
review ongoing costs or expenses periodically
•
keep guarantees to a minimum
•
underwrite applicants
•
underwrite (loss-adjust) claims
•
incentivise customers to reduce costs, eg with policy excesses
•
keep charges flexible
•
reduce future benefit payments
•
manage the expenses associated with benefit payments, by ensuring that the
costs of claims management are commensurate with the cost of the claim
Chapter 48 Summary - Development of expected values
Monitoring the experience
To analyse the performance of a product, set of products or an entire financial service
product provider over a period, the actual results obtained should be compared with
those that were expected.
The expected results can be modelled by using the profit test 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
from 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.
Sources of such surplus/profit
•
Decrements - new business levels, withdrawal/lapses, mortality and morbidity
•
Cashflows - premiums/contributions paid, investment income and gains, claim
amounts, expenses, commission
•
Other factors - salary growth, inflation, taxation.
Management "levers”
These can be used to try to:
•
control expenses
•
reduce lapses
•
reduce claims through good underwriting
•
use reinsurance to limit claims
•
follow an investment policy that increases investment returns (subject to an
acceptable level of risk)
•
increase renewals
•
adopt an effective tax management policy
Chapter 49 Summary - Reporting actual results
Accounting concepts
Although regulation and practice may vary between countries, four accounting concepts
commonly used in drawing up financial statements are:
•
going concern
•
accruals
•
consistency
•
prudence
Interpreting accounts
In analysing accounts, attention should be paid to:
•
any accounting regulation, guidance and practice in the country concerned
•
any changes in accounting practice
•
the basis used for the valuation of assets
•
any exceptional events during the accounting period
Insurance companies
The strength of the provisioning basis will affect the reported results.
Accounts can be analysed using ratios including the:
•
expense ratio
•
commission ratio
•
operating ratio
•
ratio of outward reinsurance premiums to gross premium income
Benefit schemes
Reporting on the progress of 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.
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.
•
A number of different accounting standards exist but there are some common
aims that most of these standards attempt to achieve:
•
recognising the realistic costs of accruing benefits
•
avoiding distortions resulting from fluctuations in the flow of contributions
from the employer to the pension scheme
•
consistency in the accounting treatment from year to year disclosure of
appropriate information
Differences that exist relate to the:
•
relative emphasis on the balance sheet and the profit and loss account
•
choice of actuarial method
•
flexibility in the setting of assumptions
•
smoothing of year on year fluctuations
•
amount of information to be disclosed
Possible disclosure requirements that may be needed include the:
•
assumptions
•
actuarial method
•
value of liabilities accruing over the year
•
increase in the past service liabilities at the start of the year
•
investment return 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.
Chapter 50 Summary - Risk management
Issues surrounding the management of risk
When a provider is taking on liabilities for the provision of benefits on future financial
events it needs to consider how it can minimise the risks it takes on and how it will
manage the remaining risks associated with those liabilities.
Providers need to have a comprehensive approach to risk management .to ensure that
they have adequate resources to meet their obligations.
Risk management tools
The following tools can be used to aid the management of risk:
•
reinsurance
•
diversification
•
underwriting
•
alternative risk transfer (ART)
•
management control systems
Reinsurance
In assessing the risks and the rewards, the actuary can place a realistic estimate on the
value of the benefits that would be paid by the reinsurance provider.
Proportional reinsurance can be either quota share or surplus.
Quota share is widely used by ceding providers to:
•
spread risk
•
write larger portfolios of risk
•
encourage reciprocal business
•
help satisfy the statutory solvency requirement (depending on the regulatory
•
environment).
Surplus cover enables a ceding provider to write larger risks, which might otherwise be
beyond its writing capacity.
There are different forms of non-proportional (ie excess of loss, XL) reinsurance:
•
risk XL
•
aggregate XL
•
catastrophe XL
•
stop loss
The main purpose of any form of excess of loss reinsurance is to permit a ceding
provider to accept risks that could lead to large claims. Other purposes are to reduce the
risk or insolvency from a catastrophe, a large claim or an aggregation of claims, and to
stabilise the technical results of the ceding provider by reducing claims fluctuations.
Reinsurance can also be used to provide financing.
Diversification
Risk can be managed through diversification within the following:
•
lines of business
•
geographical areas of business
•
providers of reinsurance investments - asset classes
•
investments - assets held within a class
Diversification can also be achieved by entering into reciprocal arrangements.
Underwriting
Underwriting can be used to manage risk in the following ways:
•
It can protect a provider 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 risks 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
the risk from over insurance.
Alternative risk transfer
ART arrangements can be used to manage risks by:
•
providing cost efficient cover for uninsurable risk stabilising results
•
offering greater security of payment
•
acting as a source of capital
Management control systems
Management control systems include:
•
data recording
•
accounting and auditing
•
monitoring of liabilities taken on
•
options and guarantees
Chapter 51 Summary - Asset management
Portfolio construction
Portfolios are typically constructed to meet two (often conflicting) objectives of:
•
reducing risk (often in terms of solvency and stability of cost)
•
achieving high long-term returns
The process of quantifying risk often involves dividing risk into:
•
strategic risk - the risk of the strategic benchmark relative to the liabilities
•
manager risk - the risk taken by the manager relative to his given benchmark
•
structural risk - where the aggregate of the individual manager benchmarks
does not equal the total benchmark for the fund
Risk budgeting
Risk budgeting is a process that allows risk to be allocated where it is likely to generate
higher returns and where the fund sponsor is willing to accept risk. The steps involved
are:
•
define a feasible set of asset classes
•
choose an initial asset allocation using a risk optimiser
•
monitor risk exposures
•
rebalance the portfolio when necessary due to changes in risk appetite or to
maintain the required risk exposure.
Measuring risk
Risk is most commonly measured as a tracking error from a given benchmark. It can
be measured on a forward-looking basis or a backward-looking basis. The former
involves modelling the future experience of the fund based on its current holdings and
likely future volatility and correlations to other holdings. Backward-looking measures
simply measure differences between actual fund performance and benchmark
performance and calculate a standard deviation based on this data.
The amount of risk in a portfolio can be measured by looking at the active money
positions. These are the amount of overexposure or underexposure to each stock
(relative to the strategic benchmark holding), sometimes increased (or decreased) by a
factor to allow for the higher (or lower) than average beta of the stock.
The information ratio is defined as
relative return
active return
or
.
relative risk
active risk
Downside risk measures
Commonly used tools to measure downside risk are:
•
Value at Risk
•
stress testing
Value at Risk is the potential loss over a given time period with a given confidence
interval.
Stress testing involves testing for weaknesses in a portfolio by subjecting it to extreme
market movements.
Liability hedging
Liability hedging involves selecting assets that perform exactly like the liabilities in all
states. The most familiar example is the choice of assets to hold in order to hedge unit
linked liabilities.
Potential problems may arise when the assets held are not the same as those underlying
the value of the liabilities, eg when the value of liabilities is linked to Some external
fund with unknown constituents or to an external index.
Chapter 52 Summary - Capital management
Capital needs
Capital is needed (by both individuals and companies) to:
•
provide a cushion against future uncertainty
•
overcome timing differences between cash inflows and cash outflows.
A provider of financial services products has all the same needs for capital as other
companies. However:
•
the long-term nature of financial services products, and
•
the associated uncertainties
give rise to additional capital requirements.
Capital requirements will be greater if a provider makes a decision not to hold a
portfolio of assets that replicates the liabilities.
Capital management tools
There is a range of financial tools available to providers to help them in their capital
management. These include:
•
financial reinsurance (FinRe) - a reinsurance arrangement that typically aims to
exploit some form of regulatory 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. Senor
unsecured financing and derivatives
•
derivatives
•
equity
•
internal restructuring
•
alternative reinsurance - which is used in general insurance and includes loss
portfolio transfer and spread loss.
Capital management is also a significant issue in the banking industry, where the
reasons for needing capital are similar, although the choice of available tools is slightly
different.
Chapter 53 Summary - Surplus management
Carrying out an analysis of the surplus/profit
An analysis of surplus (or profit) is a breakdown of the surplus arising over a year into
its constituent parts.
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
•
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.
Distribution of any surplus/profit arising
For life insurance companies, distributable surplus is allocated to with-profit
policyholders and/or shareholders or retained as working capital.
For other corporate institutions, the surplus belongs to shareholders and is either:
•
retained in the business
•
distributed as dividends
For benefit schemes any surplus is usually retained within the scheme, and may be used
to enhance the benefits of members, or to reduce future -contributions of members
and/or the employer.
Issues surrounding the amount of surplus to distribute
For a 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
•
policyholder expectations.
For a benefit scheme, legislation is likely to be the 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 that decision on industrial relations
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.
Chapter 54 Summary - Mergers and acquisitions
Impact of a merger or acquisition on earnings and market value
An economic gain resulting from a merger or acquisition will only arise if the two firms
are worth more together than apart. Thus, the purchaser will try to demonstrate that cost
savings and synergies will increase earnings per share from the first or second year
following acquisition. In order to assess this, we must take into account the gains and
the costs of the merger or acquisition.
In the merger or acquisition of a financial services provider, frequently cash is used to
purchase a stream of future profits. This stream of future profits may not be an
admissible asset for supervisory solvency purposes resulting in a reduction in
admissible assets and hence free assets.
The mechanics of a merger or takeover
The mechanics of a merger or takeover need to address legal, tax and accounting issues
such as:
•
competition and anti-monopoly legislation
•
form of the transaction (eg- merger, acquisition)
•
legal and regulatory processes required
•
valuation of assets (tangible and intangible)
•
treatment of goodwill
•
tax treatment of payment to proprietors
•
access to available tax shelters
The target company may:
•
approve the deal
•
contest the deal
•
seek a white knight.
Risk assessment
In assessing risk the predatory company may face the following problems:
•
valuing surplus assets, or costs of additional investment
•
valuing multiple activities
•
valuing goodwill
•
valuing unfamiliar activities and markets
•
dealing with existing contractual arrangements
•
dealing with staff relationships and redundancies
•
outstanding financial obligations, minority interests and tax
Basic information required to assess equity net cashflow includes:
•
estimate of net of tax future profits
•
value of surplus assets
•
costs and timing of any loan or debt redemption
Appraisal of management and personnel should include:
•
level of wages and salaries versus rival and neighbouring firms
•
history of industrial relations
•
sources of future labour
•
redundancy payments
•
pension scheme assets and liabilities
•
service contracts
•
stock options
External influences on mergers and acquisitions
Regulators will seek to protect existing shareholders, managers, jobs and the wider
public interest. This is balanced against the wish to avoid stifling competition.
The strict timetable for the deal can include:
•
all shareholdings above a limit to be declared
•
once a certain portion of shares have been purchased, a time delay before
further purchases can be made
•
must offer to buy rest of shares once a certain portion have been purchased
•
limited time period to gain control of company after a formal bid is made
•
if the bid fails, a time period before another bid can be made
Chapter 55 Summary - 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 or solvency capital
If the insurer’s financial position is serious (eg the solvency capital requirement is not
met), then the regulator may require the company to:
•
close to new business, or
•
establish a recovery plan (with implementation monitored closely by the
regulator)
It will also be important to project the insurer’s solvency position into the future.
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.
Sponsored benefit schemes
A benefit scheme may cease due to:
•
the insolvency of the sponsor
•
a decision by the sponsor to stop financing benefit provision
If a scheme ceases, the level of benefits that will be paid will be affected by the:
•
rights of the beneficiaries
•
expectations of the beneficiaries
•
the level of assets
Legislation and the, scheme rules may affect the level of benefits paid to different types
of benefit scheme member.
If a benefit scheme is being discontinued, the following options may exist for the
provision of the outstanding benefit payments:
•
continuation of the scheme without any further accrual of benefits
•
transfer of the liabilities to another scheme with the same sponsor
•
transfer of the funds to the beneficiary to extinguish the liability. An alternative
may exist that allows the individual to place the funds with an appropriate
insurance company or in the scheme of any new employer. Legislation may not
allow an individual to receive the capital value of their benefits.
•
transfer of the funds to an insurance company to invest and provide a benefit
An alternative may be to transfer the liabilities to a provider who will guarantee to pay
a specified level of benefits.
Chapter 56 Summary - Options and guarantees
Value of options and guarantees
Options will move in and out of the money over time depending on market conditions.
It could be assumed that the holder of an option will always exercise an in the money
option and will never exercise an out of the money option. However, this may not
always be the case.
Guarantees may become more or less onerous on the provider over time depending on
how experience develops over time.
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
The value of guarantees and their influences on consumer behaviour will vary widely
according to the economic scenarios and the sophistication of the market.
Options and guarantees are not independent. Some guarantees may make options more
valuable in certain scenarios.
Managing the risk
Risk management techniques can be used to protect the provider against the possible
adverse effects of options and guarantees given in contracts. For example:
•
liability hedging - a specific example of this is the concept of immunisation
•
option pricing methods can be used to hedge guarantees and options
dynamically
Chapter 57 Summary - Monitoring
Reasons for monitoring experience
Monitoring the experience is a fundamental part of the actuarial control cycle. 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
Data required
The basic requirement is that there is a reasonable volume of stable, consistent data,
from which future experience and trends can be deduced.
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
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 main economic factors for a benefits scheme or insurance company are interest
rates and the investment returns of various sectors. For these, the analysis is simply a
comparison between the actual returns and those assumed.
Other items of the experience that may be monitored include salary growth and
expenses.
Expense analyses
For the purpose of an expense analysis, the non-commission expenses can be split into:
•
initial expenses, which arise when liabilities are taken on
•
renewal expenses, which arise regularly during the term of the Liabilities
•
termination expenses, which arise when the liability arises, and
•
investment expenses, which relate to the management of the provider’s assets
Each of the first three can be further split according to whether the expense is
proportional to:
•
the number of contracts written or in force
•
the amount of benefit written or in force
•
the amount of premium written or in force
It is found, in practice that most of these expenses are proportional to the number of
contracts written or in force. Exceptions include:
•
marketing expenses - typically related to the amount of initial commission paid
•
underwriting expenses - mainly related to size of benefit
•
sickness and long-term care claim costs - typically related to the size of benefit
The main items of expense for a provider are:
•
salaries and salary-related expenses
•
property costs (rent, property taxes, heating, lighting and cleaning)
•
computer costs
•
investment costs (investment department, stamp duty, commission, etc)
Use of the results
The results of an analysis or experience should not be used blindly. Consideration
should be given to whether the period under investigation was typical and whether the
experience is likely to be representative of future experience. Monitoring of experience
is fundamental to effective implementation of the actuarial control cycle. This is an
iterative process as it may result in changes to assumptions used. eg in pricing.