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Microsoft PowerPoint - IAS 2004 Investment Basics CVF_II
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Microsoft PowerPoint - IAS 2004 Investment Basics CVF_II

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  • 1. Investment Basics II Investment Actuary Symposium Boston, Massachusetts November 8, 2004 Charlie Ford, Dick Mattison Agenda - Investment Basics I 1. Interest rates, term structure 2. Rate Math 3. Measurement tools 4. LIBOR 5. Swap curve 6. Credit Default Swaps 7. Derivative Market Pricing 8. Interest Rate Options 9. CAPM, Mean-Variance Efficient Frontier 10. Portfolio Design
  • 2. Agenda 11. The liability-oriented investor 12. Investment Policy and Strategy – portfolio design – risk/reward tradeoff 13. Regulatory constraints 14. Economic Evaluation of assets and liabilities 15. Risk Analysis and Control (hedging) 16. Practical Issues 11. The Liability-Oriented Investor • Mutual Fund Objective – total return against a benchmark • Pension Plan – Benefit Flows • Endowments – capital spending needs • Casualty Insurance – Long-tail claims • Life Insurance – minimum guarantees – regulatory, capital constraints • Individuals – buying a house, paying for college, retiring
  • 3. Liability-Oriented Investing • Specific goals for the funds – definite - endowment capital spending – fixed time - college education – flexible - pension or retirement – options - annuity minimum guarantees • For these, total return is inappropriate – beating S&P 500 or Lehman Corporate Index tells you nothing about whether you can meet your commitments (=liabilities) – Example - specialty portfolio Necessary Steps • Must define your: – Return objectives – Risk tolerance – Time horizon – Liquidity requirements – Regulatory and legal constraints – Tax considerations – Unique needs and preferences Investment Policy
  • 4. 12. Investment Policy Pension Example • Primary Goals – solvency – meet benefit obligations • Secondary Goals – highest long term net return possible – control risk to protect primary goals – avoid excessive contribution rate volatility Investment Policy Pension Example • Return Requirement – Adequate real return consistent with risk tolerance • Risk Tolerance – Limit exposure to absorb capital losses, in order to protect solvency, benefits – Minimize chance of increased contributions during recessions
  • 5. Investment Policy Pension Example • Time horizon – going concern basis, so open-ended • Liquidity requirements – as required by contribution less benefit cash flow projections • Regulatory and legal constraints – ERISA • Tax considerations – plan is set up as a trust, US Federal tax free (put high yielding assets in the plan) • Unique needs and preferences – Contribution and benefit projections for that plan – Plan sponsor’s tolerance for contribution volatility – Sponsor’s industry’s exposure to economic cycle Investment Strategy • Detailed guidance to portfolio managers on how to implement the Policy • Asset Mix Strategy – determines most of the long-term return – review long-range economic & capital market projections – set a target allocation between asset classes • Cash and liquidity guidance • Need for specialist advisers for high yield, REITs, etc. • Performance attribution approach – use to improve the portfolio – not to force advisers into replicating a benchmark
  • 6. Constraints on Asset Sales (a) • Accounting – IMR/Bill S-3 – AVR, for realized losses > 2 NAIC downgrade steps from purchase • Tax (US) – gains and losses taxable in year realized, along with operating income • no above/below the line distinction as with GAAP or Stat – tax-loss carryforward position – gains and losses netted within a tax year – gains and losses netted among affiliates – mergers, acquisitions may include a tax-sharing agreement Constraints on Asset Sales (b) • Embedded Value – system to measure PV(distributable earnings) and attribute its changes – securities in the portfolio have a cash flow pattern – selling changes this - need to replace the PV(cash flows) – gains due to yield curve movements incur tax, but require the full proceeds to be reinvested to replace the cash flows – gains due to credit improvement • ALM – substitution trades – yield curve slope trades • works best if you need to lengthen portfolio duration • consider the portfolio’s laddered maturity structure
  • 7. Constraints on Asset Sales (c) • Credited Rates – a sale may change the portfolio yield used to set credited rates – try to replace the sale in that segment with a new bond with at least the same yield & maturity • Policyholder Equity Issues – use caution when doing rebalance trades between asset segments backing different product classes 13. Regulatory Constraints • SEC – Registered investment adviser - investment manager – public financial statements • NAIC / SVO – asset values, ratings, capital loads • OSFI • Dept of Labor (ERISA) • State Law – asset mix constraints – liquidity filings – Derivatives Use Plan filings
  • 8. What does an Investment Actuary do? • Policy development • Advise portfolio manager – liability cash flow characteristics – accounting and product constraints on trades • Coordinate cash levels, demands with Treasury Dept. • Implement strategy, allocating new purchases by segment • Set credited interest rates, discount rates • Lead asset/liability modeling • Advise product actuaries, senior management – Investment effects on shareholder and policyholder value 14. Economic Evaluation of assets and liabilities 15. Risk Analysis and Control 16. Practical Issues
  • 9. Questions