adapting investment strategy to evolving financial reporting

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

3


List of contents


Some final remarks3


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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?


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?


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


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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


Some final remarks3


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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

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07/0

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09/0

5/20

07

11/0

5/20

07

01/0

5/20

08

03/0

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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

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09/0

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1/20

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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


Some final remarks3


30


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]

mailto:[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.

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