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Lakeland Life Insurance Company is a U.S. based underwriter of life insurance policies doing business in 23 states. In the past 5 years the company has completely revamped its product offerings, going from a focus on whole life policies to floating rate referred variable and universal life policies. The average duration of the company's insurance liabilities is eight years. Lakeland targets a 1.5% spread on investment assets over liabilities. The current expected nominal actuarial return is 5% (based on current capital market conditions), but management expects the rate environment to get more volatile in the coming months.
The company has segmented its investments into two portfolios: a fixed-income portfolio and a surplus portfolio. The fixed-income portfolio is invested primarily in long-term corporate and U.S. Treasury bonds. The surplus portfolio is currently invested in the common and preferred stock of large, well-known U.S companies. The surplus portfolio has a dividend yield of 3%. Management expects equity markets to earn 12% per year in the long term.The appropriate return objective for the fixed-income portfolio is to earn a return:

A) of 6.5% while maintaining an average duration of 8 years in order to fund insurance liabilities.

B) of 18.5% sufficient to fund long-term expansion in insurance volume and fund insurance liabilities through a total return approach.

C) sufficient to provide a spread of 1.5% over the promised rate on the company's variable rate insurance products while maintaining an average duration of 8 years, in order to fund liabilities.

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The company has segmented its investment portfolio; the purpose of the fixed-income segment is to fund insurance liabilities. The return objective should focus on providing the target spread over policy costs, which float with changes in interest rates. Therefore, while the current target is 6.5% based on current economic conditions, this target rate will change as conditions change; 6.5% is not the appropriate long-term return objective. A reasonable objective for the surplus fund is to earn a return "of 12% sufficient to fund long-term expansion in insurance volume by investing in growth-oriented securities, primarily equity." A total return approach is not appropriate for the fixed-income or the surplus portfolio.

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The appropriate risk tolerance for the surplus portfolio:

A) is the same as that of the fixed-income portfolio. While the portfolios are nominally separated for regulatory purposes, they should actually be managed as a single portfolio, because funds from each can be used to meet both goals of long-term growth and current funding of liabilities.

B) is higher than that of the fixed-income portfolio, because the funds should be used to support long-term growth in insurance volume.

C) is lower than that of the fixed-income portfolio, to guard against loss of principal and maintain a constant income stream, in order to maintain public confidence in the company's ability, in its role as a fiduciary, to fund policyholder liabilities.

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A lower risk tolerance is appropriate for the fixed-income portfolio, on the other hand, to "guard against loss of principal and maintain a constant income stream, in order to maintain public confidence in the company's ability, in its role as a fiduciary, to fund policyholder liabilities." Interest rate volatility over the short-term is not a primary concern of the surplus portfolio. The portfolios are "nominally separated," but not "for regulatory purposes;" each should have its own investment policy statement.

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The appropriate time horizon constraint for the surplus portfolio:

A) is longer than that of the fixed-income portfolio, because the purpose of the surplus portfolio is to support long-term growth in new lines of business.

B) is shorter than that of the fixed-income portfolio, because policies such as universal and variable life have shorter effective maturities than traditional life insurance products.

C) is the same as that of the fixed-income portfolio. While the portfolios are nominally separated for regulatory purposes, they should actually be managed as a single portfolio, because funds from each can be used to meet both goals of long-term growth and current funding of liabilities.

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While it's true that "…universal and variable life have shorter effective maturities than traditional life insurance products…", this does not mean the time horizon of the surplus portfolio (which is not related to the duration of the liabilities), should be shorter than the time horizon of the fixed-income portfolio (which must be matched to the duration of the liabilities). The maturity of the securities in the portfolio depends on the appropriate time horizon, not the other way around. Finally, the portfolios are "nominally separated", but not "for regulatory purposes"; each should have its own investment policy statement.

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Which of the following is NOT appropriate to include as tax or regulatory constraints in the company's Investment Policy Statement?

A) The regulatory constraint should include the recognition that, for U.S. life insurance companies, state law prevails over federal law.

B) The regulatory constraint should include the recognition that, by law, common stock holdings are typically limited to a certain percentage of assets.

C) The regulatory constraint should include a statement that the company is subject to the Prudent Expert Rule.

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This statement is not appropriate in the Investment Policy Statement; unlike pension funds, insurance companies are subject to the Prudent Investor Rule.

andytrader

Which of the following statements concerning foundations and endowments is CORRECT? Foundations are:

A) grant-making institutions and may have variable time horizons; endowments are established to permanently fund some activity, and typically have infinite lives.

B) grant-making institutions and may have variable time horizons; endowments are established to permanently fund some activity, and typically have minimum payout requirements.

C) established to permanently fund some activity and have high degrees of risk tolerance.

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Foundations are grant-making institutions and may have short or long (infinite) lives. Endowments are established to permanently fund some activity (e.g., provide scholarships) and typically have infinite lives. Endowments typically do not have minimum payout requirements. Both types of institutions typically have fairly high degrees of risk tolerance if they are long-lived.

andytrader

The risk tolerance of a foundation differs from that of the fixed-income segment of a life insurance company in which of the following ways? The risk tolerance of a foundation:

A) will typically be much greater than that of the fixed-income segment of a life insurance company.

B) will typically be much less than that of the fixed-income segment of a life insurance company.

C) and that of the fixed-income segment of a life insurance company will both be relatively low.

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The fixed-income segment of a life insurance company’s portfolio will essentially be dedicated to providing competitive returns in meeting the liabilities attached to policies sold. Hence, the risk tolerance associated with the fixed-income segment of a life insurance company will typically be less than that of a foundation, which usually has a moderate to high risk tolerance depending on spending rates.

andytrader

The return objectives for a life insurance company can be broken into two segments, the fixed-income and the surplus segments. Which return objectives are mostly associated with each segment, respectively?

A) Yield maximization and spread management.

B) Spread management and maximizing yield.

C) Spread management and capital gains.

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The return objectives for a life insurance company have mainly been associated with earning a competitive return that helps increase the spread between assets and liabilities. The surplus portfolio, however, has growth in the surplus as its main return objective, which will happen via capital gains.

andytrader

The time horizon of a non-life insurance company differs from that of a pension fund in that a nonlife insurance company’s time horizon:

A) is dependent on the uncertainties of policies sold, whereas the time horizon of a pension fund is a direct consequence of the business cycle.

B) is quite long due to the uncertainty of the liability structure associated with policies sold, whereas a pension fund's time horizon will be much shorter due to the finite life of employees.

C) may be quite short and will depend upon the characteristics of policies sold, whereas a pension fund's time horizon may be much longer, depending on workforce characteristics.

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Due to the uncertainty associated with the characteristics of policies sold and when claims will be paid, the time horizon of a nonlife insurance company will necessarily be short. A pension fund, however, will have a time horizon typically longer than that of a nonlife insurance company. The pension fund’s time horizon will be directly related to the plan sponsor’s workforce characteristics.

andytrader

Manuel Insman, CFA, has just been assigned responsibilities for insurance industry clients at Frontgate, a research and portfolio management boutique. Insman’s first concern is to identify insurance industry investment characteristics. The main purpose of this activity is to formulate a turn-key investment policy statement (IPS) that will increase the efficiency of managing client assets. By doing so, Insman hopes to add value not only to his employer, but to the firm’s investment clientele. To better understand the nuances of the insurance industry, Insman attends a one-day seminar at a local university with Saul Stetson, another portfolio manager. The seminar instructor feels that it is best to separate life insurance from property and casualty (P&C) insurance companies because of their differing investment objectives and constraints. Therefore, the morning session is devoted strictly to the life insurance industry.  
The instructor begins by reviewing how the life insurance industry has changed over the years and briefly discusses a variety of new products. He points out that changes in the industry have resulted in the classification of investment activities into segments having different return objectives. He stresses that although life insurance products have a tremendous variety of features, his research indicates that return objectives are often segmented as follows:

• Minimum Return
• Enhanced Margin Return
• Surplus Return

Insman also learns that life insurance companies are often perceived to be quasi-trust funds, and hence, require attention to objectives and constraints that are not typically found in other investment policy statements. Insman makes a list of specific factors often used to determine life insurance risk objectives or liquidity requirements:

• Cash flow volatility
• Effects of disintermediation
• Reinvestment risk
• Asset-liability mismatches
• Credit risk
• Portfolio manager style characteristics
• Asset marketability
• Liability marketability

The afternoon session of the seminar is devoted to non-life—primarily P&C—companies. The instructor explains the underwriting cycle, as well as key investment policy considerations.
Insman has a hard time keeping up with all of the information the instructor is conveying, and thinks his notes on P&C liabilities might be incorrect. To check, he asks his colleague Stetson to help him clarify the differences between P&C liabilities and those of life insurance companies.
Stetson says “I believe P&C liabilities are unknown in timing and amount, whereas life insurance company liabilities are unknown in timing but known in amount.”
Insman replies “Are you sure? I thought the instructor said that P&C liabilities are unknown in timing but known in amount, whereas life insurance companies are known in amount and timing.”
Insman continues, “Well what about the underwriting cycle? It’s approximately five to seven years and tends to follow the general business cycle doesn’t it?”
Stetson declares otherwise. “I agree that the underwriting cycle is five to seven years long but it runs counter to the business cycle.”Which of the following best characterizes enhanced margin return?

A) A net interest spread above the returns needed to fund liabilities; thus making it possible to offer competitive premiums.

B) The excess rate of return derived from using enhanced indexing portfolio management strategies.

C) Enhanced returns from equity-oriented investments designed to increase the surplus segment.

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Enhanced margin: The rate associated with efforts to earn competitive returns on assets funding well-defined liabilities. Spread management techniques are used. If done successfully, a return in excess of a policy’s crediting rate can be earned, giving life insurance companies a competitive edge in setting policy premiums and adding new business.  
Surplus return: The difference between total assets and total liabilities is surplus. The primary objective of surplus management is to generate growth, which is key to expanding insurance volume.
Minimum return: The mandated return applied to assets earmarked to meet death benefits. The minimum rate of return is a statutory rate (normally actuarially determined) that will ensure funding so that reserves are sufficient to meet mortality predictions. (Study Session 5, LOS 15.i)

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Insman wants to subdivide the list of factors impacting life insurance risk tolerance and liquidity. Which of the following set of factors best encompasses the most important risk considerations?

A) Cash flow volatility, reinvestment risk, and credit risk.

B) Credit risk, asset-liability mismatches, and portfolio manager style characteristics.

C) Cash flow volatility, disintermediation effects, and asset marketability risk.

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Cash flow volatility, reinvestment risk, credit risk, and asset valuation fluctuations are generally considered to be the most important risk factors to be evaluated when determining the risk objectives of a life insurance company. Liquidity is directly affected by the possibility of disintermediation, asset-liability mismatches, and asset marketability risk. The style characteristics of a portfolio manager are considered after risk objectives are determined, not during the formulation of the risk objectives. (Study Session 5, LOS 15.i)

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When life insurance companies assess liquidity requirements, they do NOT typically address:

A) the effects of disintermediation.

B) asset-liability mismatches.

C) risks associated with liability marketability.

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Life insurance companies are required to pay an increasing amount of attention to disintermediation and asset-liability mismatches. Both of these factors impact the liquidity of asset portfolio investments. (Study Session 5, LOS 15.i)

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Which of the following best describes the accuracy of Insman’s and Stetson’s statements about P&C versus life insurance liabilities?

A) Insman is correct; Stetson is incorrect.

B) Insman is incorrect; Stetson is incorrect.

C) Insman is incorrect; Stetson is correct.

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P&C liabilities are unknown in timing and amount. Life insurance companies know the amount of the liability (the death benefit), but not the timing. (Study Session 5, LOS 15.i)

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Which of the following best describes the accuracy of Insman’s and Stetson’s statements about the P&C underwriting cycle?

A) Insman is incorrect; Stetson is correct.

B) Insman is correct; Stetson is incorrect.

C) Insman is incorrect; Stetson is incorrect.

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Evidence indicates the P&C underwriting cycle lasts three to five years and tends to follow general business cycles. (Study Session 5, LOS 15.i)

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The unique characteristics of P&C liability structure will have the greatest effect on which of the following constraints?

A) Time horizon and liquidity.

B) Time horizon and taxes.

C) The regulatory environment and unique considerations.

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The uncertainty associated with P&C liability structure has the greatest impact on the liquidity and time horizon constraints. (Study Session 5, LOS 15.i)

andytrader

Which of the following statements regarding foundations is CORRECT?

A) An operating foundation is generally funded to support a variety of social causes over time.

B) Independent foundations provide grants to charities, educational institutions, and social organizations.

C) A community foundation is dedicated solely to support a specific organization or some on-going research initiative.

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An operating foundation is funded solely to support a specific organization or some on-going research initiative. A community foundation typically funds social, educational, or religious initiatives.

andytrader

Which of the following types of foundations do NOT have a spending requirement?

A) Independent.

B) Operating.

C) Community.

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Independent (or private) and company-sponsored foundations must spend five percent of their assets annually toward non-operating expenses to maintain their tax-exempt status. Operating foundations must use 85% of interest and dividend income to conduct the institution’s own program.

andytrader

Which of the following statements regarding foundations is most accurate?

A) An operating foundation is generally funded by the organization it is intended to support.

B) Independent foundations receive their funds from an individual, family, or group.

C) Grants from company-sponsored foundations must be made without regard to the sponsoring company’s business interest.

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Company executives usually dominate the board of trustees for a company-sponsored foundation, which may use grants to further corporate interest. A fund owned and funded by the organization it is intended to support is called an endowment, not a foundation.

andytrader

HAL Corporation is considering shifting their current defined-benefit pension plan to a cash balance plan. In an effort to educate HAL’s board of directors about cash balance plans, Mark Davidson, HAL’s Vice President of Human Resources puts together a memo that includes two statements regarding cash balance plans.

Statement 1:	The amount credited to a participant’s account in a cash balance plan is a function of salary, length of employment, and a benchmark interest rate.
Statement 2:	Converting our defined-benefit pension plan to a cash balance plan would effective shift investment risk from us as the employer to the employee.

With regard to the statements in the memo, Davidson is:

A) correct with respect to Statement 1, but incorrect with respect to Statement 2.

B) correct with respect to Statement 1 and Statement 2.

C) incorrect with respect to Statement 1, but correct with respect to Statement 2.

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Statement 1 is correct. In a typical cash balance plan, a participant’s account is credited each year with a pay credit and interest credit. The pay credit is typically based on the beneficiary’s salary, age, and/or length of employment, while the interest credit is based up on a benchmark such as U.S. Treasuries. Statement 2 is incorrect. The sponsor of a cash balance plan (employer) bears all investment risk since increases and decreases of a plan’s investments do not affect the benefit amounts promised to participants.