Achieving Consistency Between Investment Practice and Investment Assumptions for Single Premium New-Money Products

This paper investigates a technique for developing investment assumptions for pricing that are consistent with the investment practices of the company. An investment strategy is defined to be a specific allocation of investable funds among given representative fixed-income instruments. The investment strategy problem consists of two parts: how to invest funds initially received on a block of new issues and how to reinvest any excess of investment cash flow over the cash-flow needs of the block of business at later durations. Since capital market conditions are known at the time of issue but are largely uncertain for the future, the initial-investment problem is considerably easier to analyze than is the reinvestment problem. Also, for single premium business, the amount of investable funds at issue is significantly larger than the amount of investable funds at later times. Thus, the initial-investment strategy is more important than the reinvestment strategy for single premium business. This paper analyzes initial-investment strategies that produce asset-liability matching for specified durations. It shows how to express a subset of the entire region of feasible initial-investment strategies in a way that can be visualized easily and communicated to investment department officers. Practical applications of the theory to the pricing of single premium immediate annuities are given.