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IPS Pension Funds (Def B) Foundations Endowments Life Insurance Property & Casulty Ins Banks

Factors affecting risk tolerance: No defined liability stream => Above Factors affecting risk tolerance: -Conservative fiduciary principles limit risk - Face greater uncertainty than Life due to possibility - Risk measures:
(Factor change - Effect): average risk tolerance (Factor change - Effect) tolerance: of higher claims frequency => limited risk tolerance 1, Leverage-adjusted duration gap measures
1. Plan surplus (↑-↑) 1. Maintain an asset valuation reserve; - Not directly exposed to interest rate risk interest rate exposure:
2. Sponsor financial status - Short term affect: 2. Valuation concerns (losses during periods of - inlfation risk is a concern gap = D A - k*DL, where k = L/A
1. Strong recent returns and if smoothed spending rising interest rates) limit risk taking activities
D/A ratio (↓-↑)
rate < target rate => greater short-term risk 3. Control reinvestment risk - Premium income to Total surplus should be if gap=0 then balance sheet is immunized
profitability (↑-↑) tolerance 4. Credit risk (control by broad diversification) mainained between 2-to-1 and 3-to-1
3. Corr of sponsor's operations and 2. Managers are evaluated on short time frames => 5. Cash Flow volatility (uncertainty) if Int ↑
pension asset returns (↓-↑) reduced willingness to accept risk - Commond stock to surplus ratio (self imposed
and gap>0 => MV(A-L) ↓
4. Plan features (early retirement However, recently, competition has modified limitation) maintained at low levels when markets are
R-isk gap=0 => MV(A-L) does not change
lump-sum) - Long term affect: conservatism of life insurance companies, volatile
gap<0) => MV(A-L) ↑
availability (No-↑) 1. Endowment's role in operations (↑-↑) motivating them to accept and manage varying
degrees of risk to earn competitive investment 2. VAR
5. Workforce Characteristics 2. Institutions ability to adapt to drops in spending
returns 3. Credit measures
age (↓-↑) (↑-↑)
active/retired ratio (↑-↑) 3. Institution's debt (↓-↑) - Have a below average risk tolerance
- Risk relative to Liab is a primary concern (not
- Low investment risk is not the same as low risk absolute risk)
- RBC regulations further limit risk tolerance
of purchasing power impairment

Objectives: Normally: Objectives: 1. Earn a sufficient return to fund all liabilities Objectives: To earn a positive interest spread
1. Min return requirement is discount Minimum return objective = min 1. Maintain LT purchasing power (E(R) > Spending and match or exceed the expected returns 1. Offer competitive policy pricing
rate applied to compute pension liabilities spending rate + infl + investment mgnt Rate + infl + investment mgnt fees) 2. contribute to the growth of surplus through 2. Increase investment profitabilty (casualty premium
(achieve a total return sufficient to fund its exp; 2. Provide substancial resources to programs capital appreciation. rates are not sufficient to cover underwriting costs)
liabilities on an infl-adj basis.) OR 3. Growth of surplus
2. Minimize future contributions E(R) = (1+SpRate)*(1+infl)*(1+inv Smoothing rules of spending rates (SR): 4. Tax considerations
3. Generate pension income mgnt exp) - 1 1. Simple spending rule = SR* LastYr MV_end) 5. Total return management
R-eturn 2. Rolling 3-yr ave spending rule = SR*(sum of past
Greater risk tolerance => greater return 3 years MV_end)/3
objectives 3. Geometric smoothing rule (smoothing rate = w
= w* (Last years spending*(1+infl) + (1-
w)*(SR*LastYr MV_beg)

Liq requirement = Benefit payments - Anticipated (required min spending Due to their perpetual nature, liquidity requirements Derivatives market enabled life ins companies High liquidity constraints due to uncertainty in CF Liquidiy requirements are determined by:
pension contributions rate) or Unanticipated liquidity are low. However, need to have some cash to manage interest rate risk and reduced 1. Net outflow of deposits
requirements reserves for distribution (in case large capital companies' need to hold reserves. 2. demand for loans
Factors affecting liq req: project is planned)
1. Active lives (↓-↑) Minimum spending requirement Consider:
(payout rate) includes salaries of 1. Disintermediation (switching to higher
2. Workforce age (↑-↑)
L-iquidity program officers and exec; but does interest paying investments => forced to sell
3. Plan features are available (Yes-↑) not include investment mgnt fees assets at loss to meet liquidity needs)
2. Asset marketability risk (liquid v. illiquid
To avoid large fluctuations, use investments)
smoothing rules

UMIFA, Prudence Rule UMIFA, Prudence Rule Highly regulated (primarily at the State level) 1. - Asset valuation reserve (AVR) is not required, but ris- Highly regulated. RBC regulations (depending on
Eligible investments (which classes and of what base capital (RBC) requirements are established. the risk on the balance sheet, capital requirements
quality) - Assets equal to 50% of "unearned premium are determined by this regulation)
L-egal 2. Prudent investor rule + loss reserves" be maintained in "eligible bonds and
1. ERISA 3. Valuation methods administered by NAIC mortgages." The rest can be invested in a relatively
2. Plan's trustee has a fiduciary duty broad array of assets
3. Prudence Rule

Factors affecting time horizon: Majority of foundations exist into Because of the objective to maintain purchasing Different portfolio segments have different time Time-horizon is a function of two factors (usually 15-30 Generally 3-7 years (intermediate term)
1. Open to new entrants (Yes-↑) perpetuity => long time horizon power, time horize is extremely long-term. horizons (duration) years):
1. duration of casulaty liab (short-term)
2. Workforce age (↓-↑)
T-ime However, if there are large projects to be 2. underwriting cycle
3. Active/retired ratio (↑-↑) implemented soon, these cash flows will dictate
short-term time horizon
Time horizons can be multi-stage (active
lives until retirement and after)

1. Tax-paying Tax-paying
As long as minimum spending rate is
2. Very important: can defer taxes on
Pension income and capital gain are tax maintained, excise tax is 2% (but can
T-axes Tax-exempt (unrelated income is taxed) accumulated cash within a life insurance "The complexities and implications of the taxation of Fully taxable
exempt be reduced to 1%) on "Net Investment
contract tax-exempt bond income for casualty companies are
beyond the scope of this reading"-p.425 Vol2)

1. Self-imposed constraint against 1. Restriction by the donor to diversify 1. Investment managers are not always available to 1. company size Same as LIFE Historical banking relationships, community needs
investing in certain "unethical" industries 2. Prohibited investments perform due diligence if alternative investments 2. sufficiancy of surplus
U-nique 2. Plan managers are sometimes not are being considered
Circum available in small firms 2. Ethical investment policies