CHAP 19

Investment Principles and Asset Liability Matching

• Investment and asset liability management (ALM) considers investment principles, asset-liability matching requirements for general insurers, and uses projection models for appropriate investment strategies.

Introduction

• The chapter examines the issues related to a general insurer setting an appropriate investment strategy, reviewing the effect of liabilities on asset selection, the impact of free assets and non-investible funds, cashflow projections' importance, solvency requirements, and asset liability modeling.
• A case study is provided at the end of the chapter.

Features of General Insurance Liabilities

• Key features of general insurance liabilities are described, including the term of liabilities, amount, nature (fixed or real), and currency.
• Investment principles applicable to all investors should be considered.
• Asset characteristics should align with liabilities (claims and expenses) to maximize investment returns and meet contractual obligations, ensuring risk tolerance of the company.

Outstanding Term of Investments

• The interval between premium receipt and claim payment is crucial because only a portion of the premium can be invested during this time.
• The remainder funds are used to cover initial expenses.

The Influence of Inflation

• Inflation affects the final claim amounts (e.g., property repairs, medical expenses, and administrative costs).
• Claims and expenses are subject to inflation. Assets should generate income and capital values increasing with inflation to maintain a matching position.

How Liquid Do The Assets Need To Be?

• Liquid assets, like money market instruments or short-term bonds, are crucial in case of uncertainty.
• The aim is to match the short-term and uncertain nature of liabilities with the marketability and liquidity of assets.

The Effect of Free Assets on Asset Selection

• The company's free assets (assets exceeding liabilities) are available for maximizing long-term returns for shareholders/policyholders, considering liquidity and future plans, and regulatory requirements.
• The size of free assets and the technical provisions should be included in considerations. An insurer seeks to maintain free reserves to meet future liabilities, thus influencing investment decisions.

Non-investible Funds

• Some funds (like those held by agents, policyholders, or reinsurers) aren't available for investment.
• These funds can be a significant part of total assets, depending on business mix and arrangements.
• These funds represent tangible, short-term assets, and risk of non-recovery is considered.

Estimating Liability Outgo in Future Time Periods

• The projection should consider premium income and outgo, relating to business already written or future business, and include solvency and investment policies.
• The aim is to estimate the overall liability outgo by calculating gross claim payments, reinsurance recoveries, expenses, outstanding premiums, and tax/dividend payments for each period.
• A realistic view of likely outgo is essential to develop the investment strategy.

Claim Payments and Recoveries

• Claims payments are a major liability, including all future payments, IBNR (incurred but not reported) claims, and claims from yet-to-expire risks.
• Expenses related to claim handling could be explicitly or implicitly considered.

Premium Income

• Premiums are usually calculated gross, deducting commissions and initial costs.
• Allowance for outstanding premiums is needed when projected cash-flows aren't annual.

Tax and Dividend Payments

• Future tax and dividend payments are projected, considering investment returns, tax rates, and dividend policies.
• Dividends and tax are primarily driven by profitability estimates.

Sensitivity of Cashflow Results to Changes in Assumptions

• Liability and asset sensitivities are crucial to assess how investment projections react to various circumstances.
• Stochastic models can indicate the impact of varying assumptions on asset and liability outcomes..

Solvency Requirements

• Solvency positions depend on asset volatility, especially when market-based valuation methods are used.
• The method to value liabilities should align with the valuation of assets to ensure accuracy and consistency.
• Regulation requires that insurers ensure future solvency by considering how well assets are matched to liabilities in terms of risk, as well as the insurer's strategy to build an adequate solvency base.

The Influence of Supervisory Authorities on Investment Policy

• Supervisory authorities may impose restrictions on assets held and their valuation methods.
• These restrictions could be based on general or specific product lines, or specific insurer situations.

Objectives and Constraints

• The primary objective of investment strategy is maximizing return, while meeting claims and expense liabilities.
• Risk appetite (as determined by management and shareholders) is a significant constraint, influencing the acceptable level of risk and potential profitability.

External Influences

• Tax treatments, legal/ethical/voluntary restrictions, and statutory requirements all impact investment policies.
• Competition also influences strategies.
• Insurer-specific factors affect a company’s risk appetite. This includes the internal structure, and management decisions regarding risk.

Risks

• Liquidity risk arises from the risk of insufficient cash for immediate liability settlement.
• Currency risk affects asset/liability values due to exchange rate fluctuations.
• Market risk relates to changes in assets' market value and the volatility in asset/liability positions.
• Economic risk stems from investing during negative economic periods.
• Credit risk involves counterparties' inability to fulfill their obligations, such as reinsurance failures.
• Operational risk comes from internal fraud or mismanagement within investment operations.
• Relative performance, contagion, and group/entity risk also affect investment strategy.

Investment Policy in Practice

• Insurers normally face three different cashflow scenarios (ongoing insurer, run-off insurer, insurer post-large event).
• Each situation requires separate investment strategy, matching, and liquidity considerations.

Asset Liability Modeling (ALM)

• ALM simultaneously models asset and liability outflows to assess the relationship between them.
• This modeling approach accounts for the time-dependent outflows.
• Different investment mixes and assumptions are tested in ALM to determine the appropriate investment strategy.

ALM for Developing an Investment Strategy

• ALM employs stochastic and deterministic techniques to model both assets and liabilities.
• Testing various situations/ scenarios for asset-liability interactions is crucial.
• ALM ensures that assets adequately support liabilities, optimizing risk and solvency.

Case Study

• The case study focuses on applying ALM to analyze a potential change in an insurance company's retention level, assessing its impact on future profitability.
• The process of determining future liability outgo and assessing the best retention level is applied in the case study.