Faculty of Actuaries Institute of Actuaries

EXAMINATIONS

September 2000

Subject 401 — UK Fellowship Investment

Paper Two

EXAMINERS’ REPORT

ã Faculty of Actuaries
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Subject 401 (UK Fellowship Investment) — September 2000, Paper 2 — Examiners’ Report

1 The company might consider the following types of bonds:

• UK Corporate Bonds
• Local Authority Bonds
• Foreign Bonds
• Eurobonds
• Bonds Issued In Overseas Bond Markets
• Asset Backed Securities

UK Corporate Bonds

UK companies issue to domestic lenders a wide range of bonds including

mortgage debentures, debentures and unsecured loans. These bonds are listed
on the London Stock Exchange and traded using a competing market making
system with prices disseminated on SEAQ. UK corporate bonds are, generally
speaking, much less liquid than UK government bonds because the amount in
issue is much smaller, dealing costs are higher and the average daily turnover is
much smaller. The credit quality - the promise to pay interest and repay capital
when due - of these bonds varies greatly from one company to another. It is
important to examine interest and capital cover for such issues as well as the
prospects for the company and the industry.

Local Authority Bonds

Local authorities raise money through local taxes and from central government
grants. The money is used to fund capital projects at local level. There are two
types of local authority bonds:

1. Short-dated negotiable bonds (referred to as Local Authority Bonds)

and

2. County and corporation stocks.

The first of these are usually issued for terms of one year but terms of up to five
years are possible. The second category is more akin to UK government bonds
because of their term and coupon characteristics.

Despite the fact that most local authority bonds are quoted, marketability tends
to much poorer than UK government bonds mainly because of the small size of
issues. Credit quality would be better than many UK corporate bond issues.

Foreign Bonds (Bulldog Bonds)

Bulldog bonds are issued in the UK by overseas borrowers. The bonds are
denominated in Sterling. In terms of coupon and term these bonds tend to be
similar to UK government gilts but the credit quality and marketability would,
as a general rule, be a lot lower. The credit quality range stretches from that of
supra-national bodies like the World Bank to issues by governments of countries
where political stability is not a given and issues by corporates of poor credit
ratings. The marketability of most of bulldogs is hampered by the small size in
issue. The larger bulldog issues tend to be more marketable than UK corporate
debentures.

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Eurobonds

Eurobonds are debt securities issued internationally by a syndicate of banks

which underwrite the issue and sell it to their clients. The marketability of some
of these issues is comparable with that of UK government bonds.

Overseas Bond Markets

In descending order of size the US, Japan, Germany and the UK are the largest
government bond markets in the world. In terms of strips markets, the UK is
the largest followed by France & the UK. Japan and German tend not to offer
maturities beyond 10 years while France and the UK offer maturities that
extend up to 30 years.

Interest conventions & frequency of coupon payment (semi-annual/annual pay

bonds) vary from market to market. The way in which yields are quoted also
vary from market to market. The problem with this group of bonds is that they
are denominated in the currency of the issuing government and represent an
asset liability mismatch for the company.
Asset Backed Securities

Asset backed securities arise from the securitisation of revenue streams owned
by the borrower. The income from a pool of assets (like a group of mortgages
originated by a bank) is repackaged as repayments on an issue of bonds which
are then sold in the market. Collateralised mortgage obligations (CMOs) and
Mortgage Backed Securities (MBSs) are perhaps the best known types of asset
backed securities.

MBSs arise from the securitisation of a pool of residential mortgages. Investors

in MBSs are sold units in the pool and can sell on their investment afterwards in
a secondary market. In the US, the mortgages in the pool are usually fixed-rate
mortgages and are guaranteed by a government agency so there is a very very
low risk of default. When interest rates fall many borrowers refinance their
mortgages at lower interest rates. This gives rise to pre-payment risk on MBSs.

The significant feature of CMOs is that they are an attempt to manage the
prepayment risk from a pool of mortgages by splitting the bonds that are issued
into different classes. Each class receives interest at the rate specified for the
pool of mortgages but entitlement to capital repayment is ranked across the
classes. Let’s say there were three classes. The class with the highest rank
would receive all capital repayments until it was repaid. The middle ranking
class is next to be repaid until it is fully repaid. The bottom ranking class is the
last to be repaid. Variations on the approach define maximum and minimum
rates of repayment in each class thus further reducing prepayment risk.

Securitised mortgage repayments can be structures so as to include interest only

(IO) and principal only (PO) securities. Payments on the IO version cease when
the mortgage is repaid so the total amount of money an investor will receive is
significantly more uncertain than usual. On the PO, if the prepayments are
earlier than assumed when the PO is priced, it becomes more valuable than
expected and vice versa. These types of asset backed securities are very risky
investments.

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Subject 401 (UK Fellowship Investment) — September 2000, Paper 2 — Examiners’ Report

Liability Matching

The liabilities of a general insurer transacting the classes of business outlined in

the question are very short with little or no inflation risk. Most claims will be
settled within a period of months. Claim outgo is quite uncertain so liquidity is
very important.

Some of the bonds mentioned above would be totally unsuitable because of their
lack of liquidity. Only the very large issues from the high credit quality
borrowers in the corporate, foreign and eurobond markets would be suitable in
terms of liquidity. Local authority bonds tend to be very illiquid and by and
large unsuitable. Few if any mortgage backed securities would be suitable as a
match for the liabilities. Overseas bonds add an unwarranted element of
currency risk and are likely to be unsuitable as a match for the liabilities.

New Skills

The investment department would need to acquire new skills in the area of credit
quality evaluation if it were decided to move outside the UK Government bond
market which is characterised by high levels of liquidity, fiscal privileges, low
dealing costs and the ultimate in credit quality.

Possible Approach

In view of their lack of liquidity, holdings in these types of bonds could not be
traded actively. However, given the extend of the free reserves, it might be
possible to hold a portfolio of bonds issued by the high credit quality borrowers
and giving a high running yield.

2 Dear Chairman,

RE: XYZ ASSET MANAGEMENT

You have asked me to review the investment management capabilities of XYZ

Asset Management. Before preparing the full report and analysis, I am writing
to outline the areas I shall investigate and analyse and the reasons why.

1. Past performance

While I understand that the trustees are not unhappy with the
performance achieved by XYZ for the Scheme, it is nevertheless important
to analyse it in detail.

We would look at:

• Past performance relative to the appropriate benchmark — in your

case this is the CAPS median. We tend to favour looking at
comparative rolling 3 year returns as a good indicator of fund
management ability, and would compare this with other large
investment managers.

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• In additional we would look at the volatility of performance relative to

the CAPS median achieved by XYZ — this is a good indicator of the
risk profile of XYZ. Again we would show how XYZ compares with
other large investment managers.

• In-house volatility — we would look at the dispersion of returns

achieved by XYZ for portfolio with similar mandates to your own
scheme … ideally one would wish for a small dispersion thus implying
XYZ manages its portfolios consistently.

• Attribution analysis — we would analyse where XYZ’s performance or

underperformance relative to its benchmark comes from i.e. asset
allocation, sector allocation, stock selection etc., and how this
compares with XYZ’s stated investment philosophy.

• Portfolio style analysis — XYZ proposes to operate a growth style in its

portfolio construction. It is important to analyse the makeup of your
scheme’s stock portfolios to make sure there is a bias towards such
stocks i.e. typically growth stocks have low dividend yields or high
price to book ratios and high expected earnings. We can also look at
how the UK and US equity portfolio performances compare with the
established growth indices for these markets.

2. Client relationship

The quality and speed of delivery of the quarterly investment reports is a

good indication of the efficiency of the XYZ’s mid and back office. Given
the size of your scheme’s assets, your relationship should be at XYZ’s
executive board level.

3. People

The importance of the senior people who work for XYZ is self-evident. Our
research will examine:

• The quality of senior people — their experience, track record and

commitment to the business.

• Depth of resources — the number of investment staff involved for each

major sector, systems at their disposal, the dependence on any “star”
fund managers.

• Continuity of staff — this is a critical determinant of success. It is

important to examine whether the investment fund managers who
have achieved the returns for the scheme are still in XYZ, and if not,
what changes have been made. We will also examine ho XYZ plans to
retain key staff.

4. Investment process

The firm should have a clear process of how it expects to outperform the
competition/benchmark. We will analyse this process in detail, looking at

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Subject 401 (UK Fellowship Investment) — September 2000, Paper 2 — Examiners’ Report

how research is carried out, buy and sell disciplines and how asset
allocation is determined. It is important to try to evaluate the consistency
of the process so that the exploitation of market inefficiencies is
repeatable. We will also relate this process to the performance attribution
analysis carried out. The decision structure will also be analysed in terms
of its ability to enable making fast effective decisions.

5. Business management

XYZ has grown funds and attracted new clients over the past few years.
We will examine this growth in detail and also how they have planned for
and coped with this growth, specifically looking at:

• Investment in new capacity — hiring new staff ahead of the new

business or improving the technology and systems to allow fund
managers to cover more clients.

• Maintaining the quality of staff/not impairing the investment process

by having more people involved.

• Solving the liquidity problem of growth — this could affect the firm’s
ability to buy/sell stocks and may require adjusting the investment
process.

This full analysis will obviously generate a lot of information about XYZ.
The key points about our review are that:

• Performance statistics should be used to gain a better understanding

of the investment style of XYZ.

• The quality of XYZ as an investment organisation reflects a

combination of factors the most important of which are the quality of
the investment process and the quality of the people.

6. Preparedness for future developments

We need to investigate XYZ’s ability to cope with the Year 2000 change,
and also its plans (if any) to change the way it manages European assets
in the new Euro zone.

I look forward to presenting you with the full review.

Yours sincerely,

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