Not my idea of plain English... Chapter 15 page 19

[Bill SD]

Chapter 15 page 19 (top) quotes the core reading: "Unless risk-free zero-coupon bonds can be used it is rarely possible to achieve pure matching, although a close approximation to a perfect match may be possible for certain life insurance products, such as guaranteed income bonds."

Am i correct that this (combination of sentences) means that:
1. A zero coupon bond in a risk-free issuer can be a pure match for a life assurance product (since no reinvestment risk of the coupons);
2. Guaranteed income bonds can be an almost perfect match for "certain life insurance products" -these are unnamed (as i'm assuming that a 'guaranteed income bond' is an asset rather than liability)but presume refer to an insurance product (from Chapter 6) which offers regular payments, like an income drawdown or income protection?

Thanks in advance for confirming or correcting me.

 

[Richie Holway]

Hi Bill,

Addressing your points in turn:

1. Yes, that’s correct: although more likely a portfolio of zero-coupon bonds (rather than just one such bond), each chosen with a maturity date (and amount) that matches the expected liability cashflow profile of the life insurance product. However, there does of course remain some element of mismatching to the extent that the liability cashflows may not turn out to be as expected.
2. Guaranteed income bonds are life insurance products, so are what is being referred to in the ‘for certain life insurance products’ phrase. They are an example of the investment bonds described in Chapter 6, and have an inbuilt guarantee. It is typically the case that derivatives can be purchased that match that guarantee.

I hope this helps.
Richie

 

[Bill SD]

2.Guaranteed income bonds are life insurance products, so are what is being referred to in the ‘for certain life insurance products’ phrase. They are an example of the investment bonds described in Chapter 6, and have an inbuilt guarantee. It is typically the case that derivatives can be purchased that match that guarantee.

Thanks very much Richie -two follow-up questions on part 2.

How do Guaranteed income bonds (or annuities for that matter) meet the "key features of life insurance products" mentioned in chapter 6 page 3, such as "typically only one claim, certain claim amount, etc?

They sound like products which bank offer (Guaranteed Income Bonds | Fair Investment). Your answer mentions derivatives as a good match for a Guaranteed income bond. Wouldn't a cheaper but suitable match be for the insurer to purchase a fixed-rate long-term bond offering a large coupon (similar to the guaranteed income)?

 

[Richie Holway]

Thanks very much Richie -two follow-up questions on part 2.

How do Guaranteed income bonds (or annuities for that matter) meet the "key features of life insurance products" mentioned in chapter 6 page 3, such as "typically only one claim, certain claim amount, etc?

They sound like products which bank offer (Guaranteed Income Bonds | Fair Investment). Your answer mentions derivatives as a good match for a Guaranteed income bond. Wouldn't a cheaper but suitable match be for the insurer to purchase a fixed-rate long-term bond offering a large coupon (similar to the guaranteed income)?

On the link you provide, the wording ‘guaranteed income bond’ is being used to describe what is basically a fixed rate savings account. The guaranteed income bond referred to in the course is a product that is sold by life insurers, and so may offer a slightly higher benefit on death than would be achieved otherwise (in order to be classified as a life insurance product). The basic structure is typically the provision of a guaranteed level of income throughout the specified term and then a return of initial investment at maturity. Bear in mind that as they are only briefly mentioned in the course without further detail, you would not be expected to know the details of how they work for CP1.

Considering the ‘key features of life insurance products’ you mention:

• There is typically only one claim: this does apply to investment bonds (including guaranteed income bonds) in the sense that the lump sum benefit is payable on death, on earlier surrender or at maturity. Several types of life insurance product can pay out benefits in income form (such as from annuities, some investment bonds, income drawdown, income protection insurance, some long-term care insurance etc) – that isn’t what this phrase is referring to.
• Certain claim amount: this phrase applies to conventional without-profit life insurance products (and not to unit-linked or with-profit business). It can apply to the basic guaranteed income bond, as indicated in the basic description above, and also applies to a standard level immediate annuity (which pays an amount that is known and certain until death). An annuity with payments linked to an inflation index pays an amount that is known in real terms but uncertain in nominal terms.

Using a fixed-rate long-term bond to back this product would not generate a high enough level of income to make it an attractive product. To be able to offer a marketable product, the life insurer would typically invest in riskier assets in order to generate higher returns, using derivatives to protect the downside and enable the guarantees to be offered. There is a version of the product (that has been offered in the past) which only guarantees the return of capital at maturity if a specified index has not fallen by more than x% (in which case, only a stated % of the initial amount would be returned, or possibly only the initial amount minus x% of the income received). This design enables the insurer to offer a more attractive level of income, and would normally be supported through the use of an option on the index.

Richie