Notesale: Turn your study into money

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Insurance companies, pensions …
Monday, 7 November 2016

2:03 pm

Objectives:
- Understand the role and importance of insurance and pensions in the
financial system
- Understand he effect of their investment decision on the market
- Distinguish between the group of organisations that allocate funds to
purchase securities
Insurance and pensions:
- They play an important role in the financial system through:
○ Reducing and transferring risk
○ Hold financial securities and control enormous funds
○ Their investment decisions have effects on the market - due to the
large size of fund
Another group of organisations:
- Group that allocates funds to the purchase of securities are:
○ Mutual funds
○ Unit trusts
○ Investment trusts
○ Sovereign wealth funds
- Helps investors spread their savings across securities
Life insurance covers risk of loss of life:
- Term life - pays out on death within a set time
- Whole life - pays out when the insured dies
- Annuities - provides regular income until the death of insured
- Endowment life - pays out at a set future date on earlier death of the insured;
when the insured dies, the payment goes out after a while

Investment of surplus:
- Some contracts allow the policy holder to determine how the surplus is
invested
- There are tax deferral advantages compared to a normal investment as there
is no tax paid until the payout policy
Annuity contracts:
- Usually a lump sum is used to buy a lifetime annuity
- It can be fixed or variable
- Can start immediately or be deferred
- Accumulated value can depend in a complicated way on the value of stock
indices
- There may be penalty free withdrawals
Property-casualty insurance
- Conerned with the loss or damage to property (fire, theft accident etc)
- Concerned with legal liability exposures
- Risk of fraud etc
When do premiums change:
- For life insurance, premiums usually stay the same throughout the life of the
contract
- For property-casualty insurance, the premiums change from year to year as
risks are reassessed
- For health insurance, premiums can rise because of overall rise in cost of
healthcare but not because the health risks of policy holder increases - that
risk assessment is done when the contract is signed
Moral hazard and adverse selection:
- Moral hazard - risk that the existence of the insurance policy causes the
policy holder to take more risks
- Adverse selection - tendency for insurance company to attract bad risks
because they cannot distinguish between good and bad risks
Typical balance sheet of:
- life insurance

policy holder to take more risks
- Adverse selection - tendency for insurance company to attract bad risks
because they cannot distinguish between good and bad risks
Typical balance sheet of:
- life insurance

Note that investments are mostly long term corporate bonds
- Property casualty insurance

Investments are usually liquid shorter maturity bonds
Insurance companies and financial crisis:
- The near collapse of insurance giant AIG (American international group) was a
major moment in the financial crisis
- AIG, with 1tril assets prior to the crisis, lost 99
...
The federal
reserves stepped in with a 85bil loan to keep the company from going under
- What exactly happened is still a mystery as there were multiple moving parts
- The company's credit deault swaps played the major role in the collapse,
losing AIG 30mil
○ By selling CDS, assets that act like insurance contracts on bonds
...
5mil in 1940 to 12tril in 2011
- Open ended funds are the most common
- This means that the number of shares in the fund increases as investors buy
more and goes down as they redeem shares
- All purchases and sale of shares are at the 4pm net asset value of the fund determined by price of underlying asset
Types of fund:
- Equity
- Bond
- Money market
- Index
Closed ended fund:
- Consists of a fixed number of shares that are traded in the same way as the
shares of any other company
- The share price tends to be less than the NAV calculated form the market
value of the investment (underlying assets)
- Price determined by demand and supply in the market
Exchange traded finds:
- For high frequency traders
- Track an index
- High frequency and the price normally corresponds to that of the index
(below the index)
- Started by and institutional investor that deposits a block of securities and
obtains shares in the fund - the shares are traded on an exchange
- Prices dictated by the market and changes constantly
Benefits of ETFs over close ended funds:
- Can be bought and sold (or shorted) at any time of the day
- Holdings are disclosed twice a day
- Investments do not have to be sold to cover redemptions
- Share price close to NAV of underlying investments
Problems with mutual funds:
- Late trading
○ The mutual funds are normally purchased at the closing price
- Market timing
○ To be strategic in choosing a date/time to trade stocks

Problems with mutual funds:
- Late trading
○ The mutual funds are normally purchased at the closing price
- Market timing
○ To be strategic in choosing a date/time to trade stocks
○ People who monitor these mutual funds closely (dealers/brokers) can
spot patterns
○ They can choose a good time to buy/ sell their assets, the way they
manage clients account may suffer if they serve their own interests
instead
- Front running
- Direct brokerage
○ Being charged more, in terms of fees which may include transaction
costs
...

Hedge funds take more risks to earn more
Unit trusts:
- Investment funds administered as trusts issuing units
- The trust's trustee is the legal owner of the assets
- Value of the trust is determined by value of underlying asset

Investment trusts:
- Set up by companies
- Share prices of investment trusts frequently sell at large discount to NAV
- Freedom to borrow

- Share prices of investment trusts frequently sell at large discount to NAV
- Freedom to borrow

Sovereign wealth funds:
- Collective funds set up and managed by governments
- See formative assignment
Hedge funds:
- Mutual funds are restricted because
○ Shares must be redeemable at any time
○ NAV calculated daily
○ Investment policies must be disclosed
○ Use of leverage is limited
- Hedge funds are not subject to these restrictions
Hedge fund fees:
- Typical fee structure of 2 plus 20% - the fund charges 2% management fee
per year plus and incentive fee of 20% of any net (after management fees)
profits
- There may be lock up periods where funds cannot be withdrawn
- Other features: hurdle rates, high water marks and clawbacks
Funds of funds:

per year plus and incentive fee of 20% of any net (after management fees)
profits
- There may be lock up periods where funds cannot be withdrawn
- Other features: hurdle rates, high water marks and clawbacks
Funds of funds:
- They invest in the portfolios of hedge funds
- The typical fee used to be 1 plus 10% but is now much lower
Incentives of hedge fund:
- The hedge fund manager's fee gives the manager a call option on the
performance of the fund each year
- They have an incentive to take high risks
- Should a hedge fund manager choose an investment with 0
...
6% probability of a 60% loss?
Prime brokers:
- They handle hedge fund trades, determine the maximum leverage and
collateral requirements, borrow securities when hedge fund is shorting
- Large hedge funds typically use more than one prime broker
- The risks that hedge funds take are to some extent controlled by their prime
brokers
Private equity:
- Refers to the type of investment aimed at gaining significant, or even
complete, control of a company in hopes of getting a high return

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