What alternative investments are of interest to life companies?
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1 Life Conference 2011 Scott Robertson and Niall Clifford, KPMG LLP What alternative investments are of interest to life companies? 21 November 2011
2 Contents 1. What alternative assets have low correlation to market risk? 2. How to model alternative asset risks? 3. What is the capital benefit from increased diversification? 4. What non-financial risks should we consider? 1
3 Contents 1. What alternative assets have low correlation to market risk? 2. How to model alternative asset risks? 3. What is the capital benefit from increased diversification? 4. What non-financial risks should we consider? 2
4 What alternative assets have low correlation to market risk? How does the behaviour of alternative assets differ to standard assets? Diversification benefit Difficult to find assets with low correlation to market risks Tail dependency Important to understand correlations at different stress levels 3
5 What alternative assets have low correlation to market risk? (cont.) Size and liquidity of alternative asset markets Alternative assets that companies might consider are: hedge funds insurance risk commodities climate change / green energy investments infrastructure projects 4
6 What alternative assets have low correlation to market risk? (cont.) Further discussions on: 1. Equity release mortgages 2. Insurance-linked securities (including life settlements) 3. Gold 5
7 What alternative assets have low correlation to market risk? (cont.) Equity release mortgages Features Different products e.g. Lifetime Mortgage - provider lends the borrower cash and takes a mortgage charge on the property Fixed rate mortgage to homeowners aged 55+ No negative equity guarantee Typical LTV s range from c.15% to 50% depending on age Pensioners (aged 65+): 33% of property equity for this age group (c. 249bn) is in London and the South East of England (Source: Key Retirement Solutions Index at end Aug 2011) Benefits Improves return on equity by providing additional yield and provides risk diversification for investors (no credit risk) Issues Dynamism of different risks, idiosyncratic nature of the asset Modelling house price inflation and correlation with prepayment risk 6
8 Equity release mortgages (cont.) LTV Expected Cashflow Profile from Equity Release Mortgages Source: KPMG analysis Term (years) Expected Cashflow NEG 7
9 Equity release mortgages How to gain access to this asset class: Origination Do it yourself Silently fund an existing originator Purchase loan books from existing holders Market update made new advances of 206.2m in Q3 2011, 12% up on Q ( 184.9m) 10% increase in the number of equity release customers over the same period average amount released in an equity release mortgage was 50k (6% increase over the last 12 months) Source: SHIP s Q press release 8
10 What alternative assets have low correlation to market risk? (cont.) Life Settlements / Traded Life Policies Features Whole of life policies sold by policyholders to investors with the investors paying the premiums until the policies mature on death Senior life policies (over-65s) Benefits Potential to offer stable, predictable returns regardless of investment market performance Risks Longevity risk Default risk Interest rate risk (but can be hedged) Markets Estimated US$11.8bn of life settlement transactions in 2008, with US$31bn of US life settlement in force at the end of 2008 Source: Merlin Stone Report (August 2010) 9
11 Insurance-linked securities Wider insurance-linked securities market Life and health issuance of US$525m occurred during the 12 months to 30 June 2011 (this was the second largest year of issuance since the US$1.1bn that was issued in the year to 30 June 2007) Total bonds at risk of US$11.5bn as at 30 June 2011 (down US$1.7bn from a year earlier) Swiss Re successfully transferred US$180m of extreme mortality risk to the capital markets through the Vita securitisation programme in August Swiss Re issued a US$50m longevity bond during Q (first ever public transaction of a longevity bond) that covered future variability in longevity trends) Swiss Re issued an excess mortality bond of US$175m during October 2010 Source: AON Benfield report: Insurance-Linked Securities Consistency and Confidence
12 What alternative assets have low correlation to market risk? (cont.) Gold Benefits Flight to quality, safe haven, intrinsic value Particularly the case in a world of negative real interest rates Hedge against financial consequences from economic and political turmoil Low or negative correlation with other assets at the tails Markets Gold bullion Gold ETFs / Funds Gold certificates Other forms 11
13 What alternative assets have low correlation to market risk? (cont.) Gold compared to some other asset classes Index Level (Rebased to 100 at start) Dec 1997 Jun 1998 Dec 1998 Jun 1999 Dec 1999 Jun 2000 Dec 2000 Jun 2001 Dec 2001 Jun 2002 Dec 2002 Jun 2003 Dec 2003 Jun 2004 Dec 2004 Date Jun 2005 Dec 2005 Jun 2006 Dec 2006 Jun 2007 Dec 2007 Lehman Jun 2008 Dec 2008 Jun 2009 Greece Dec 2009 Jun 2010 Ireland Dec 2010 Portugal Jun 2011 Italy? Dec 2011 Source: Bloomberg and KPMG analysis Gold FTSE Gilts FTSE All-World Equities Iboxx Corporates 12
14 Contents 1. What alternative assets have low correlation to market risk? 2. How to model alternative asset risks? 3. What is the capital benefit from increased diversification? 4. What non-financial risks should we consider? 13
15 Standard Formula from QIS5 SCR Adj BSCR Op Market Health Default Life Non-life Intang Interest rate SLT Health CAT Non-SLT Health Mortality Premium Reserve Equity Mortality Premium Reserve Longevity Property Longevity Disability CAT Spread Disability Morbidity Currency Expenses Concentration Expenses Revision Liquidity Revision CAT Key: Source: Included in the adjustment for the loss-absorbing capacity of technical provisions under the modular approach. CEIOPS QIS5 technical specification 14
16 How to model alternative asset risks? Equity release mortgages SCR Adj BSCR Op Market Health Default Life Non-life Intang Interest rate SLT Health CAT Non-SLT Health Mortality Premium Reserve Equity Mortality Premium Reserve Longevity Property Longevity Disability CAT Spread Disability Morbidity Currency Expenses Concentration Expenses Revision Liquidity Revision CAT Key: Included in the adjustment for the loss-absorbing capacity of technical provisions under the modular approach. 15
17 How to model alternative asset risks? Life settlements SCR Adj BSCR Op Market Health Default Life Non-life Intang Interest rate SLT Health CAT Non-SLT Health Mortality Premium Reserve Equity Mortality Premium Reserve Longevity Property Longevity Disability CAT Spread Disability Morbidity Currency Expenses Concentration Expenses Revision Liquidity Revision CAT Key: Included in the adjustment for the loss-absorbing capacity of technical provisions under the modular approach. 16
18 How to model alternative asset risks? Gold Gold Careful consideration needs to be given to the potential treatment under Solvency II: Standard Formula Internal Model 17
19 How to model alternative asset risks? Gold SCR Adj BSCR Op Market Health Default Life Non-life Intang Interest rate SLT Health CAT Non-SLT Health Mortality Premium Reserve Equity Mortality Premium Reserve Longevity Property Longevity Disability CAT Spread Disability Morbidity Currency Expenses Concentration Expenses Revision Liquidity Revision CAT Key: Included in the adjustment for the loss-absorbing capacity of technical provisions under the modular approach. 18
20 Contents 1. What alternative assets have low correlation to market risk? 2. How to model alternative asset risks? 3. What is the capital benefit from increased diversification? 4. What non-financial risks should we consider? 19
21 Analysis of the capital benefits from increased diversification Demonstration of two case studies Equity release mortgages Life settlements 20
22 Contents 1. What alternative assets have low correlation to market risk? 2. How to model alternative asset risks? 3. What is the capital benefit from increased diversification? 4. What non-financial risks should we consider? 21
23 What non-financial issues should we consider? Operational risk Systems and controls Reputational risk Inaccurate life expectancy estimates Data complications lack of granularity Servicing risk Liquidity risk Tracking risk Ownership risk Legal risk 22
24 What non-financial issues should we consider? (cont.) Exit risk Communication with the Board, regulator and third party providers Internal interdepartmental communications Compliance costs and governance In-house expertise What to do if things go wrong Model error, valuation and misestimation risk Tax risk Regulatory risk 23
25 Questions or comments? Expressions of individual views by members of The Actuarial Profession and its staff are encouraged. The views expressed in this presentation are those of the presenter. 24
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