Investment Strategy in Crisis

Document Sample
Investment Strategy in Crisis Powered By Docstoc
					Thoughts on investment


      FIDELITY INTERNATIONAL




Joint Regional Seminar – July 2009

“Practical Actuaries and Financial Reporting”


Robert Chen                    FIAA, FIA, FCAA, FRM

Director, Head of Insurance, Asia Institutional
Fidelity International
    List of contents
        FIDELITY INTERNATIONAL




    1     Impact of evolving financial reporting standards


    2     Impact of the financial crisis


    3     Some final remarks




1
    List of contents
        FIDELITY INTERNATIONAL




    1     Impact of evolving financial reporting standards


    2     Impact of the financial crisis


    3     Some final remarks




2
    A time of change
       FIDELITY INTERNATIONAL




      Many new changes being brought about
                                     Purpose                  Replaces         Driven by            Arrived?

               MCEV             Shareholder value       TEV                Management and    Yes
                                measurement                                Investors
               IFRS             Statutory reporting     Local reserving    Regulators        Phase I – Yes
                                                                                             Phase II – Soon
          Solvency II Capital requirement Local solvency                   Regulators        Soon
                                          requirement


      Wide ranging impact on actuarial work
                                                                                          Capital      Investor
                                 Pricing       Modelling       Reporting   Investment
                                                                                        management     relations

              MCEV                                                                                    

               IFRS                                                                                   

         Solvency II                                                                                  


3
    Common themes
      FIDELITY INTERNATIONAL




      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



4
    Common aim
      FIDELITY INTERNATIONAL




      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




       Source: CEIOPS


5
    What is the “ideal” investment strategy?
       FIDELITY INTERNATIONAL




      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)




                                1   11   21           31         41   51
                                              Remaining years

                                                 Liability C/F


      How would you invest your assets?
6
    What is the “ideal” investment strategy?
       FIDELITY INTERNATIONAL




      A matched book of risk free fixed interest investments?




                    1           11   21               31               41   51
                                            Remaining years

                                          Liability C/F    Asset C/F




7
    What is the “ideal” investment strategy?
       FIDELITY INTERNATIONAL




      Where would this place the company? A, B, or C?
               "Economic" Return Measure




                                           C

             A                             B

                                               "Economic " Risk Measure


8
    What is the “ideal” investment strategy?
       FIDELITY INTERNATIONAL




      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



9
     Being more realistic
        FIDELITY INTERNATIONAL




       The supply and liquidity of Asian bonds on the long end is limited
        LCY (’bn)             Total                               Over 10 Years            Over 20 Years

        Country                  Amount                  Issues    Amount         Issues    Amount         Issues

        China                     11,413                    309     1,721           36        234            9
                                                                    (15%)         (12%)      (2%)          (3%)
        Hong                         313                    116       4             5          -             -
        Kong                                                        (1%)          (4%)
        Malaysia                     330                    155       33            7          -             -
                                                                    (10%)         (5%)
        Singapore                    124                     35      11             3          -             -
                                                                    (9%)          (9%)
        South                    492,986                    409    18,699          29          -             -
        Korea                                                       (4%)          (7%)
        Taiwan                     4,044                     89     1,073           24        75             2
                                                                    (27%)         (27%)      (2%)          (2%)
        Thailand                   4,036                    231      385           11          7             2
                                                                    (10%)         (5%)       (0%)          (1%)
        Source: Bloomberg 26 June 2009, Fidelity International


10
     Some alternatives
        FIDELITY INTERNATIONAL




       Remedies

              Using swaps to extend duration

              Invest in overseas bonds and hedge back

              Diversify the duration mismatch risk into other risk sources




11
     Some alternatives
        FIDELITY INTERNATIONAL




       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




12
     Some alternatives
        FIDELITY INTERNATIONAL




       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)




13
     Some alternatives
        FIDELITY INTERNATIONAL




       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




14
     Some alternatives
          FIDELITY INTERNATIONAL




        Diversifying into other asset classes


          Insurers can
      spread investment
       risks over a suite
        of risk sources:
       market risks and
      counterparty risks




          Source: CEIOPS, Fidelity International


15
     Comparison with older standards
        FIDELITY INTERNATIONAL




       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




16
     Comparison with older standards
        FIDELITY INTERNATIONAL




       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




17
     List of contents
         FIDELITY INTERNATIONAL




     1     Impact of evolving financial reporting standards


     2     Impact of the financial crisis


     3     Some final remarks




18
     Mistrust among banks over each other’s solvency
           FIDELITY INTERNATIONAL




                                                             31 December 2008




                                      15 Sep 2008:
                                      Lehman Brothers file
                                      for bankruptcy
                                      Merrill Lynch taken
                                      over by BoA




      Source: Bloomberg 4 June 2009


19
20
                                                                         %




                                               0
                                                   1
                                                         2
                                                               3
                                                                              4
                                                                                            5
                                                                                                    6
                                                                                                          7
                                  01/05/2007

                                  03/05/2007

                                  05/05/2007

                                  07/05/2007

                                  09/05/2007




     Source: Bloomberg 5/1/2009
                                                                                                                                         FIDELITY INTERNATIONAL




                                  11/05/2007

                                  01/05/2008

                                  03/05/2008
                                                                                                              Base Rates




                                  05/05/2008

                                  07/05/2008

                                  09/05/2008

                                  11/05/2008
                                                              UK
                                                                         US
                                                                              Euros




                                                                          %
                                                   2.5
                                                             3.5
                                                                                      4.5
                                                                                                    5.5




                                               2
                                                         3
                                                                         4
                                                                                                5
                                                                                                          6




                                  01/01/2007

                                  03/01/2007
                                                                                                                                                                  Central banks cut rates and inject liquidity




                                  05/01/2007

                                  07/01/2007

                                  09/01/2007

                                  11/01/2007

                                  01/01/2008

                                  03/01/2008

                                  05/01/2008

                                  07/01/2008
                                                                                                                Government Bond Yields




                                  09/01/2008

                                  11/01/2008

                                  01/01/2009
                                                                         UK
                                                                               US


                                                               Germany
     A dislocated market: A depression, not recession
     in the price
            FIDELITY INTERNATIONAL




                                               A Long History of Credit Spreads
           8                                                Moodys BAA Corporate Spread
                  %
           7
           6
           5
           4
           3
           2
           1
           0
               25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05


     Source: Bloomberg, Moodys (31.01.1925 to 27.10.2008)



21
     Asset backed paper market seizure
            FIDELITY INTERNATIONAL



                                                         ABS spreads by sector
      1400                                         EURO ABS Floating AAA                                   Concern about the consumer
                  OAS spread (Basis points)



                                                   EURO ABS Floating AA
      1200
                                                   EURO ABS Floating A                                     Concern about losses

      1000                                         EURO ABS Floating BBB
                                                   EURO ABS Floating RMBS                                  Concern about refinancing

        800                                        EURO ABS Floating CMBS
                                                                                                      ABS – Asset Backed Securities
        600                                                                                           Securities whose cash flows are
                                                                                                      linked to an underlying asset pool.
        400
                                                                                                      CMBS – commercial mortgage
                                                                                                      backed securities
        200
                                                                                                      RMBS – residential mortgage backed
                                                                                                      securities
            0
                04                                  05         06           07                   08   Cash flows from CMBS and RMBS
                                                                                                      are backed by mortgage pools.


                                              Uncharted territory – ABS never experienced anything like this before
     Source: FIL Ltd, Lehman Brothers ABS indices, Option Adjusted Spreads, 30 September 2008.



22
     Market Volatility
            FIDELITY INTERNATIONAL




                                      VIX – volatility on S&P      31 December 2008

                          MOVE – treasury bond market volatility




      Source: Bloomberg 29 May 2009


23
     A tail event come true
        FIDELITY INTERNATIONAL




        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




24
     Don’t forget about the short term
        FIDELITY INTERNATIONAL




        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



25
     Don’t forget about the short term
        FIDELITY INTERNATIONAL




        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?




26
     Investment implications
        FIDELITY INTERNATIONAL



       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




27
     List of contents
         FIDELITY INTERNATIONAL




     1     Impact of evolving financial reporting standards


     2     Impact of the financial crisis


     3     Some final remarks




28
     Aims of life office investment
        FIDELITY INTERNATIONAL



       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
                                                       Shareholder capital injection



                                     Premium
                           Income




                                      Income

                                    Investment
                                      Income
                                                                                                   Liabilities
                                      Benefit                      Assets
                                      Outgo
                            Outgo




                                     Expenses,
                                    Commission
                                                                                                    Surplus
                                       Tax



                                                                            Policyholder profits
                                             Shareholder profits
                                                                             (participating products only)



29
     3 reasons for investment
       FIDELITY INTERNATIONAL
        Long term – Liability profile, asset class behaviour




                                                                                                                Short term – Take advantage of market conditions
                                                                                 Matching




                                                               Diversification              Yield enhancement




30
     Final remarks
        FIDELITY INTERNATIONAL



       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


31
     FIDELITY INTERNATIONAL




                              Thank you

                                     Robert Chen, FIAA, FIA, FCAA, FRM
                                     Director, Head of Insurance
                                     Asia Institutional
                                     Fidelity International

                                     Tel: +852 2629-2407
                                     Email: robert.chen@fil.com


32
      Important Information
            FIDELITY INTERNATIONAL




     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




33

				
DOCUMENT INFO
Description: Investment Strategy in Crisis document sample