FIDELITY INTERNATIONAL
Thoughts on investment
Joint Regional Seminar – July 2009
“Practical Actuaries and Financial Reporting”
Robert Chen FIAA, FIA, FCAA, FRM
Director, Head of Insurance, Asia Institutional
Fidelity International
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List of contents
Impact of evolving financial reporting standards1
Some final remarks3
2 Impact of the financial crisis
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FIDELITY INTERNATIONAL
List of contents
Impact of evolving financial reporting standards1
Some final remarks3
2 Impact of the financial crisis
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Many new changes being brought about
Wide ranging impact on actuarial work
A time of change
Purpose Replaces Driven by Arrived?
MCEV Shareholder value measurement
TEV Management and Investors
Yes
IFRS Statutory reporting Local reserving Regulators Phase I – YesPhase II – Soon
Solvency II Capital requirement Local solvency requirement
Regulators Soon
Pricing Modelling Reporting InvestmentCapital
management
Investor relations
MCEV
IFRS
Solvency II
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Trend of convergence:
Separation in the evaluation of market and non-market risks
Explicit treatment of financial options and guarantees
Explicit allowance for actions by policyholders and management
Financially driven wealth maximising behaviour
Much of this is not new information
Well managed companies have been using this information for the better part of a decade!
These latest reporting standards
Aims to bring more uniformity in approach
Makes the basis and impact of strategic decisions more transparent
Common themes
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Aims to promote sound management of financial risks by insurers
More granular assessment of risks, down to policy level
More specific treatment of various risks
Common aim
Source: CEIOPS
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Assume you live in a world where all bond and equity assets are available in unlimited quantities
Assume you’re running an investment portfolio that backs a simple block of non-participating whole of life policies in run-off, with the following best estimate cash flow profile (deterministic basis)
How would you invest your assets?
What is the “ideal” investment strategy?
1 11 21 31 41 51
Remaining years
Liability C/F
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A matched book of risk free fixed interest investments?
What is the “ideal” investment strategy?
1 11 21 31 41 51
Remaining years
Liability C/F Asset C/F
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"Eco
nom
ic" R
etur
n M
easu
re
"Economic " Risk Measure
Where would this place the company? A, B, or C?
What is the “ideal” investment strategy?
A B
C
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Likely to be C
Why is the risk measure not zero?
The portfolio is exposed to a range of other risks
Cash flows may be different from the best estimate, e.g.
Higher than expected surrenders – cash out-flows emerge earlier => realisation risk
Mortality improvements – cash out-flows emerge later => reinvestment risk
Without a perfect hedge, impossible to eliminate risk
Why is the portfolio not on the efficient frontier?
We have restricted ourselves to a single asset class
Diversification will allow us to achieve a higher rate of return while assuming the same level of risk
What is the “ideal” investment strategy?
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The supply and liquidity of Asian bonds on the long end is limited
Being more realistic
LCY (’bn) Total Over 10 Years Over 20 Years
Country Amount Issues Amount Issues Amount Issues
China 11,413 309 1,721(15%)
36(12%)
234(2%)
9(3%)
Hong Kong
313 116 4(1%)
5(4%)
- -
Malaysia 330 155 33(10%)
7(5%)
- -
Singapore 124 35 11(9%)
3(9%)
- -
South Korea
492,986 409 18,699(4%)
29(7%)
- -
Taiwan 4,044 89 1,073(27%)
24(27%)
75(2%)
2(2%)
Thailand 4,036 231 385(10%)
11(5%)
7(0%)
2(1%)
Source: Bloomberg 26 June 2009, Fidelity International
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Remedies
Using swaps to extend duration
Invest in overseas bonds and hedge back
Diversify the duration mismatch risk into other risk sources
Some alternatives
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Swaps
More liquid on the longer end than bonds – but still over-the-counter
Example: a 20-year fixed for floating swap
Company would invest in a rolling portfolio of 1-year bonds
Pass the return to the swap counterparty, who will pay a flat rate over 20 years
Same effect as holding a 20-year bond
Exposed to credit risk of the counterparty
Some alternatives
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Forex hedging
Why take the currency risk?
Markets for foreign bonds may be deeper
Foreign bonds may be available for longer maturities
Possible to hedge away all the risks?
Hedge market is illiquid and thin beyond 1 year
Bid / offer spread could be 200 – 300 bps for 10-year currency forwards
Rebalancing could be costly
Rolling hedge: eventual effect is unpredictable, but helps with risk measures with short time horizon (e.g. 1 year)
Some alternatives
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Beware of convexity
Some assets (e.g. MBS) could have a long Macaulay / modified duration, as well as high expected yields
But their convexity may be the opposite sign to liabilities
Example: MBS
Cash flows are funded by underlying mortgages
Level of prepayments drive the amount of cash flow that holders receive
If interest rates rise:
Liability: lapse rates increase, liability cash flows brought forward
Mortgages: pre-payments fall, asset cash flows deferred
Some alternatives
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Diversifying into other asset classes
Some alternatives
Insurers can spread investment risks over a suite of risk sources: market risks and
counterparty risks
Source: CEIOPS, Fidelity International
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Impact of “de-risking” through making assets and liabilities more matched:
MCEV
More matched assets and liabilities would reduce time value of financial options and guarantees and improve MCEV
IFRS Phase II
Reduction in reserves through a reduction in the market consistent value of liabilities and margins attributable to asset liability mismatch
Solvency II
Reduction in capital requirement through a reduction in the market consistent value of liabilities and the MCR and SCR arising from asset liability mismatch
Comparison with older standards
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Impact of “de-risking” through making assets and liabilities more matched:
Traditional EV
Lower investment return assumption
Subjective downward adjustment to RDR
Some statutory valuation regimes
No change to valuation rate, since valuation interest rate set at policy inception
Some solvency capital regimes
No impact, since old EU-style solvency margin is % statutory reserves + % sums at risk
Relatively less incentive
Comparison with older standards
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List of contents
Impact of evolving financial reporting standards1
Some final remarks3
2 Impact of the financial crisis
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Source: Bloomberg 4 June 2009
Mistrust among banks over each other’s solvency
15 Sep 2008:
Lehman Brothers file for bankruptcy
Merrill Lynch taken over by BoA
31 December 2008
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Central banks cut rates and inject liquidity
Source: Bloomberg 5/1/2009
Base Rates
0
1
2
3
4
5
6
7
01/0
5/20
07
03/0
5/20
07
05/0
5/20
07
07/0
5/20
07
09/0
5/20
07
11/0
5/20
07
01/0
5/20
08
03/0
5/20
08
05/0
5/20
08
07/0
5/20
08
09/0
5/20
08
11/0
5/20
08
%
Euros
US
UK
Government Bond Yields
2
2.5
3
3.5
4
4.5
5
5.5
6
01/0
1/20
07
03/0
1/20
07
05/0
1/20
07
07/0
1/20
07
09/0
1/20
07
11/0
1/20
07
01/0
1/20
08
03/0
1/20
08
05/0
1/20
08
07/0
1/20
08
09/0
1/20
08
11/0
1/20
08
01/0
1/20
09
%
US
UK
Germany
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A dislocated market: A depression, not recession in the price
A Long History of Credit Spreads
Source: Bloomberg, Moodys (31.01.1925 to 27.10.2008)
0
1
2
3
4
5
6
7
8
25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05
%Moodys BAA Corporate Spread
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Asset backed paper market seizure
ABS spreads by sector
Uncharted territory – ABS never experienced anything like this before
Source: FIL Ltd, Lehman Brothers ABS indices, Option Adjusted Spreads, 30 September 2008.
Concern about the consumer
Concern about losses
Concern about refinancing
0
200
400
600
800
1000
1200
1400
04 05 06 07 08
OA
S s
prea
d (B
asis
poi
nts)
EURO ABS Floating AAA
EURO ABS Floating AA
EURO ABS Floating A
EURO ABS Floating BBB
EURO ABS Floating RMBS
EURO ABS Floating CMBS
ABS – Asset Backed Securities
Securities whose cash flows are linked to an underlying asset pool.
CMBS – commercial mortgage backed securities
RMBS – residential mortgage backed securities
Cash flows from CMBS and RMBS are backed by mortgage pools.
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Market Volatility
Source: Bloomberg 29 May 2009
VIX – volatility on S&P
MOVE – treasury bond market volatility
31 December 2008
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Crash in share prices
Low swap rates as at 31 December 2008
Very high implied volatilities as at 31 December 2008
Elevated corporate bond spreads
Crash in prices of asset backed paper
Re-assessment of counterparty risk
Lack of confidence in life insurers
Change in new business mix
A tail event come true
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Defensive asset allocation
Reduced % in high risk assets such as equities, either actively or though allowing the values to drift
Large cash position
Not likely to be long term
Diversify
Geographical
Asset class
Concentration in individual assets
Manager style: active vs passive
Don’t forget about the short term
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Strengthen risk management in asset selection
Stress test the assets: choose the severity carefully
Know the variables that affect the investment returns, challenge the asset manager on the assumptions underlying the illustrations they use
Failure of institutions thought to be “too large to fail” has forced a re-pricing of credit risks
This is shown through the dramatic widening of corporate bond spreads
(some of the spread is due to liquidity, but BoE analysis still shows a heightened assessment of credit losses)
Do your own credit analysis?
Don’t forget about the short term
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Investment implications
Opportunities
Equity market recovery
Most markets have posted strong recovery YTD 2009
Achieve a wide geographical spread and a bias into early cyclical stocks to capture benefits of recovery
Inflation linked fixed income
Monetary measures have significantly increased money supply and increased the likelihood of higher inflation rates beyond the immediate term
Inflation linked fixed income will provide better protection than treasuries
Corporate bonds
Increased spreads reflect strong discounts applied due to lack of investor confidence
Creates great value add opportunities for investors with capabilities in fundamental credit analysis
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List of contents
Impact of evolving financial reporting standards1
Some final remarks3
2 Impact of the financial crisis
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Aims of life office investment
Aim of life insurance investment is to satisfy the twin aims of:
Being able to deliver deliver policyholder benefits with reasonable certainty
Maximising returns to shareholders and policyholders
Premium Income
AssetsLiabilities
Surplus
Investment Income
Shareholder capital injection
Shareholder profitsPolicyholder profits
(participating products only)
Benefit Outgo
Expenses, Commission
Tax
Inco
me
Out
go
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3 reasons for investment
Matching
Diversification Yield enhancement
Lo
ng
term
–L
iab
ility
pro
file
, ass
et c
lass
be
ha
vio
ur S
ho
rt term
–Ta
ke a
dva
nta
ge
of m
arke
t con
ditio
ns
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Final remarks
Evolving Reporting standards and the financial crisis may have changed the way we view the world, but …
ALM principles have not changed
Short term focus:
How to benefit from the current market conditions
Take full advantage of the economic recovery through TAA and asset selection
Long term focus:
Continue to strengthen ALM and risk management capabilities
Impossible to eliminate all risks – adopt a measured approach in taking the right mix of risks
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Thank you
Robert Chen, FIAA, FIA, FCAA, FRM
Director, Head of InsuranceAsia InstitutionalFidelity International
Tel: +852 2629-2407Email: [email protected]
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Important Information
Investment involves risk. All views expressed cannot be construed as an offer or recommendation by Fidelity. Fidelity shall not be held liable for damages arising out of any person's reliance upon this information. Any person considering an investment should seek independent advice on the suitability or otherwise of the particular investment.
Fidelity, Fidelity International, and Fidelity International and Pyramid Logo are trademarks of FIL Limited.
Ref. SG09/249
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