Managing Institutional Investor Portfolios －LO insurance, management, companies, contrast, liability

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 5: Portfolio Management for Institutional Investors
Reading 21: Managing Institutional Investor Portfolios
LOS m: Compare and contrast the asset/liability management needs of pension funds, foundations, endowments, insurance companies, and banks.

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Which of the following statements concerning the liability structures of life insurance companies and nonlife insurance companies is TRUE? For:

A) life insurance companies the amount of the liability is not known, and the timing of the liability is not known.

B) nonlife insurance companies the amount of the liability is known, but the timing of the liability is not known.

C) nonlife insurance companies the amount of the liability is not known, but the timing of the liability is known.

D) life insurance companies the amount of the liability is known, but the timing of the liability is not known.

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Answer and Explanation

For life insurance companies the amount of the liability is known, but the timing of the liability is not known. Both are unknowns for the nonlife insurance company.

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One difference between the asset liability management techniques between a life and nonlife insurance company is liability:

A) payment amounts are known for the nonlife insurance company.

B) payment amounts are known for the life insurance company.

C) payment amounts are not known for the life insurance company.

D) timing is known for certainty with the life insurance company.

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Answer and Explanation

The liability payment amounts for the life insurance company are known, whereas they are not known for the nonlife insurance company.

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One difference between the asset liability management techniques between a life and nonlife insurance company is liability payment:

A) amounts are known for the nonlife insurance company.

B) amounts are unknown for the nonlife insurance company.

C) amounts are unknown for the life insurance company.

D) timing is known with certainty for the nonlife insurance company.

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Answer and Explanation

Liability payment amounts are unknown for the nonlife insurance company.

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Asset liability management techniques between a life and nonlife insurance company are similar in that liability payment:

A) timing is unknown for both.

B) amounts are unknown for both.

C) amounts are known for both.

D) timing is known for both.

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Answer and Explanation

The payment timing for liabilities is unknown for both the life and nonlife insurance companies.

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Which of the following underlying processes provides a natural framework from which to establish investment criteria and objectives?

A) Community reputation risk management.

B) Asset-liability management.

C) Credit risk management.

D) Marketability risk management.

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Answer and Explanation

Asset-liability management is a natural framework from which a bank creates investment portfolio objectives.

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Asset-liability management (or surplus management) is the primary consideration in formulating an investment policy and asset allocation for a(n):

A) defined contribution pension plan.

B) foundation.

C) endowment.

D) defined benefit pension plan.

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Answer and Explanation

Sponsors of defined benefit pension plans are responsible for funding any shortages of a pension plans future liabilities. Therefore, they are typically concerned with the difference between the value of the pension plans assets and liabilities. Most of a sponsors financial obligation for a defined contribution plan is fulfilled once the plan is initially funded so asset-liability management is not a concern. Foundations and endowments must have investment policies that maintain spending rates determined by their objectives and constraints.

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Which of the following statements most accurately describes asset-liability management for the specified institution?

A) Managers of foundations typically attempt to match the duration of assets and liabilities.

B) Asset allocation for pension funds must accommodate a five percent spending so the fund may maintain its tax-exempt status.

C) Asset allocation for pension funds is generally unaffected by regulatory constraints.

D) Risk tolerance for an endowment is determined by the spending rate and its importance to the operating budget of the recipient.

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Answer and Explanation

Managers of pension funds typically attempt to match the duration of assets and liabilities. Asset allocation for foundations must accommodate a five percent spending rate so the fund may maintain its tax-exempt status. Asset allocation for pension funds is generally affected by regulatory constraints, such as restrictions on private and speculative debt.

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Cayse Medical Foundation (CMF), a private foundation, subsidizes research into an array of medical conditions. An external donor funds its operating expenses. Manny University Endowment (MUE) is a $500 million fund that contributes $30 million per year to the universitys operating budget, or about half the universitys budget, which grows by at least the inflation rate. Which fund has a higher risk tolerance?

A) CMF because CMFs spending rate is low and the foundation does not need to grow its assets.

B) CMF because CMF has a longer time horizon.

C) MUE because CMF has greater liquidity constraints.

D) MUE because the university is highly dependent on it.

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Answer and Explanation

Because CMF operating expenses are funded externally, CMFs spending rate is low, which increases its ability to tolerate risk. In addition, compared to endowments, which typically have to maintain the purchasing power of its assets, foundations need not grow their assets thereby increasing their risk tolerance. Both CMF and MUE have very long, perhaps infinite, time horizons. CMF must maintain a five percent spending rate to preserve its tax-exempt status, while MUEs spending rate is six percent. MUEs higher spending rate creates a higher liquidity constraint and lower risk tolerance. Because the university is quite dependent on the MUE, MUE has a lower risk tolerance than CMF.