Alternative Investments for Life Assurance Companies and Pension Funds

1
Alternative Investments for Life Assurance
Companies and Pension Funds

• Working Party of the Society of Actuaries in
  Ireland
• Peter Caslin
• Colin Murray

2
Background to the Paper

• Life Companies Selling Cross Border
• Falling Equity Markets
• Demand for Alternative Products
• Allowed Under the Regulations?
• Rationale/Issues Arising?
• Consumer Protection Issues?

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This Morning

• Peter Caslin
• Rationale For Alternative Investments
• Hedge Fund Index Returns
• Regulatory Position
• Selection Criteria
• Colin Murray
• New EU Rules
• Consumer Protection Issues
• Review of Some Products
• Unit Pricing Issues

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Alternative Investments - Rationale

• Low Correlation With Traditional Assets
• Returns Comparable to Traditional Assets
• Diversification Same Return/Lower Risk

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Assumption 1 Low Correlation

• Hedge Funds With Low Correlation to Traditional
  Asset Classes Exist
• Problems
• Coefficients of Correlation Not Stable
• May Increase in Volatile Markets
• Need To Compare Historic Monthly Returns from
  Hedge Fund and Investors Portfolio

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Assumption 2 Comparable Returns

• Historic Returns Jan 1988 to Dec 2000
• VAN Hedge Fund Index 19.4
• SP 500 (Divs Reinvested) 16.7
• US Equity Mutual Funds 13.3
• Problems With Indices
• Survivorship Bias
• Selection Bias
• Stale/Managed Pricing

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Hedge Fund Indices - Problems

• Survivorship Bias
• No Account Taken of Leavers
• Returns Overstated by 2-3 p.a.
• Volatility/Kurtosis Understated
• Sharpe Ratio Overstated (A-r)/Vol
• Mutual Fund Indices Same Problem
• Role For Actuaries?

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Hedge Fund Indices - Problems

• Selection Bias
• Funds Choose to Participate in the Index
• Returns may be Back-Filled
• Stale/Managed Pricing
• Illiquid Assets
• Reduction in Volatility
• Overstates Sharpe Ratio

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Regulatory Position - Conclusions

• UK Life Rules Prevent Hedge Fund Investment
• Look-Through Rules
• Permitted Derivatives
• Not All Countries Apply Look-Through Rules

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Other Selection Criteria

• Due Diligence Satisfactory?
• Integrity/Competence of Key Management
• Risk Management Processes
• How is Value Added?
• Custodian/Banker/Stockbroker/Administrator
• Returns Normally Distributed?
• Potential Problems with Volatility/Sharpe Ratio
• Must Measure Kurtosis

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Other Selection Criteria

• Regulated in OECD
• Greater Disclosure
• Specified Performance Measurement
• Fit and Proper Persons Tests
• Conflicts of Interest Less Likely
• Liquidity
• Lock-up Periods Indicate High Leverage/Lack of
  Liquidity
• Smoothed Pricing of Illiquid Assets

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Summary

• Sound Rationale
• Appropriate Selection Criteria
• Problems With Index Statistics
• Regulatory Position
• UK Unlikely
• Other EU Countries - Possibly

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Alternative Investments for Life Assurance
Companies and Pension Funds

• Working Party of the Society of Actuaries in
  Ireland
• Peter Caslin
• Colin Murray

14
Developments Disclosure

• New EU rules
• Overseas developments and practices
• Life assurance disclosure

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New EU Rules

• Fund of funds
• Derivatives
• Index trackers
• More complex risk spreading rules
• Further investor protection

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Overseas

• UK FSA considering permitting sales of hedge
  funds to retail investors
• Isle of Man
• Risks Fact Sheet
• Due diligence established
• ISVAP permit with rules on min premium, income
  and wealth thresholds

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Life Assurance Disclosure

• No requirements under Third Life Directive
• General Good Requirements

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Ireland

• Disclosure Regulations
• Society of Actuaries Guidance Notes

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Disclosure Regulations

• Minimum product/commission disclosure
• Deterministic projections
• Appears to be no explicit requirement show
  charging structure

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Guidance Notes

• GN1 ..mislead as to their expectations
• GN22
• 2.2 fair, clear and not misleading
• 3.1 reinforces PRE requirements of GN1
• 4.8 additional information should be disclosed
• 6.1 misleading impression of charging basis
• 6.3 fairer illustration of the expected benefits

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Guidance Notes

• Reflect all performance fees
• Reflect risks

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GN22 Additional Disclosure Recommendations

• 95 confidence interval
• Probability of losing money
• Maximum drawdown

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Other Disclosure Recommendations

• Carry out due diligence of funds
• Differing Levels for Retail PPB
• Disclose
• Parties
• Charges
• Counterparty risk
• Statement of risks (signed off by policyholder)

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Alternative Investments

• Risks and Rewards

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Risks Rewards
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Risks Rewards
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Risks Rewards
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Risks Rewards
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Risk Rewards
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Unit Pricing
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Unit Pricing

• Performance fee.
• Payable when fund assets above High Water Mark.
• Each generation of investors has own High Water
  Mark.

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Unit Pricing

• Different tranches of units for different
  investment dates.
• Accruals in unit pricing.
• Hedge fund managers already do this.
• May not be practical. Other methods possible.

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Alternative Investments for Life Assurance
Companies and Pension Funds

• Working Party of the Society of Actuaries in
  Ireland
• Peter Caslin
• Colin Murray