Schweser QBank 2017 portfolio management and wealth planning 06 portfolio management for institutional investors

The current under-funded status of the pension plan should have no bearing on the risk tolerance or return objectives of the plan's investment policy statement.. Explanation The return o

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Test ID: 7426254Portfolio Management for Institutional Investors

Which of the following defined benefit pension plans has the greatest ability to accept risk?

Plan Age of

workforce

Ratio of active to retired participants

Sponsor's debt ratio

Sponsor's profitability

Which of the following statements about defined contribution investment policy statements (IPS) is least accurate?

Procedures are established to insure that a myriad of individual investor objectives and

constraints can be handled

IPS for defined benefit and defined contribution plans are similar in nature

Plan sponsors should provide education about investing plan funds

Explanation

Defined contribution plans call for quite a different IPS than do defined benefit plans

Which of the descriptions in the table below most accurately describes the liquidity requirements for life and non-life insurancecompanies?

Liquidity Requirements for Insurance Companies

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Description Fixed income segment Surplus segment Fixed income segment Surplus segment

The fixed income segment of life insurance company portfolios has a relatively high liquidity requirement Asset-liability mismatch,disintermediation, and asset marketability risk all contribute to the relatively high liquidity requirement

For non-life insurance companies, the fixed income segment of their portfolios has a relatively high liquidity requirement due to theuncertainty of claims

A defined benefit plan should:

construct an investment policy statement (IPS) after a manager has been chosen for the

plan

invest plan assets without distinction between the tax consequences of returns generated

from income and returns generated from capital gains

review investment performance on a yearly basis

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In the United States, the provisions of the Employee Retirement Income Security Act

(ERISA) must be adhered to regardless of any state or local laws and regulations that

govern pension investment activity

Due to either ethical or political objections, a pension plan may disallow investments in certain

types of traditional or alternative asset classes

The basic tenet of the Employee Retirement Income Security Act (ERISA) is that pension

plans be managed with equal regard for the interests of plan sponsors and plan beneficiaries

Due to the current under-funded status, relatively older workforce age, and high

retired-lives proportion, Ace's pension plan risk tolerance profile needs to be moderate to

high The plan's return objective should be to generate high levels of return to cover the

plan shortfall through aggressive growth investment vehicles

Due to the current under-funded status, relatively older workforce age, and high retired-lives

proportion, Ace's pension plan risk tolerance profile is low to moderate The plan's return

objective should be to meet the pension benefit payment requirements of the high level of the

current retired-lives proportion of participants and those soon approaching retirement

Matching plan assets with plan liabilities is a must

The current under-funded status of the pension plan should have no bearing on the risk

tolerance or return objectives of the plan's investment policy statement Pension plans should

pursue as high a return as possible in order to minimize contributions and/or increase benefits

Explanation

Although Ace's willingness to take risk may be high, the current under-funded status, older workforce age, and high proportion of retiredlives dictates a lower than average ability to take risk Hence, risk tolerance should be low to moderate Assets should be chosen thatdeliver returns that match liability payments of current retirees and those about to enter retirement

A nonlife insurance company is facing the end of its underwriting cycle What should the firm do with respect to the duration of its income portfolio and the liquidity constraints in its policy statement? The duration of the nonlife insurance company's fixed-incomeportfolio should be:

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lengthened in expectation of decreasing claims, and the investment policy statement

should reflect the possibility of a decreasing claims environment in its liquidity

constraint towards the end of its underwriting cycle

shortened in expectation of increasing claims, and the investment policy statement should

reflect the possibility of an increasing claims environment in its liquidity constraint towards the

end of its underwriting cycle

lowered in expectation of decreasing claims, and the investment policy statement should

reflect the possibility of a decreasing claims environment in its liquidity constraint towards the

end of its underwriting cycle

Explanation

Nonlife insurance companies experience a noted underwriting cycle that generates low claim submissions at the beginning of the cycleand high claim submissions at the end of the cycle The investment policy statement should reflect this changing underwriting cyclereality, which would impact a greater liquidity constraint towards the end of the cycle Bond portfolio durations should be lowered, if theyhave not been already, to meet the impending increased claims submissions

Which of the following defined benefit pension plan segments generates the greatest liability noise? The greatest source ofliability noise is that from:

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Question #10 of 175 Question ID: 465311

Which of the following statements most accurately describes asset-liability management for the specified institution?

Managers of foundations typically attempt to match the duration of assets and

liabilities

Risk tolerance for an endowment is determined by the spending rate and its

importance to the operating budget of the recipient

Asset allocation for pension funds is generally unaffected by regulatory constraints

Explanation

Managers of pension funds typically attempt to match the duration of assets and liabilities Asset allocation for foundationsmust accommodate a five percent spending rate so the fund may maintain its tax-exempt status Asset allocation for pensionfunds is generally affected by regulatory constraints, such as restrictions on private and speculative debt

Which of the following statements best compares the legal and regulatory constraints when managing a pension plan versus managing anendowment fund?

State pension laws generally supersede Federal pension laws regarding pension plans

whereas endowment funds are primarily regulated at the Federal level

Endowment funds are managed according to the "prudent expert" rule while benefit plans are

managed under the "prudent investor" rule

Pension plans are managed according to the Employee Retirement Income Security Act while

endowment funds are governed by the Uniform Management Institutional Funds Act

Endowment plans are held to a standard known as the "prudent investor" rule, which states that fiduciaries must adhere to fundamentalduties of loyalty, impartiality and prudence as well as maintain overall portfolio risk at a reasonable level and provide for the reasonablediversification of investments Fiduciaries must also act with prudence in deciding whether and how to delegate authority to experts and

in selecting and supervising agents

Ed Simon, CFA, has been assigned the arduous task of assessing the slight nuances concerning the investment objectives and

constraints for foundations and endowments Simon's supervisor has requested a full report on these differences and how they affect the

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investment policy statements

Simon thought it best to first look at differences in return objectives between foundations and endowments Which of the following bestindicates differences between the return objectives of foundations and of endowments?

Foundation return objectives depend on the time horizon of the foundation, whereas

endowment return objectives are to provide a permanent base of funding

Foundation return objectives are to provide a permanent base of funding whereas endowment

return objectives depend on the time horizon of the endowment

Endowment returns usually are dictated by a rule-of-thumb of "5.3% + inflation," whereas

foundation return objectives are dictated by spending rules

Explanation

Foundations may be finite-lived entities, but endowments are created to provide a permanent base of funding

Simon next turned his attention to the differences in risk objectives between foundation and endowment investment policy statements.Which of the following best describes the main difference between foundation and endowment risk objectives?

Foundation risk tolerance is dependent on the time horizon of the foundation, whereas

endowment risk tolerance is dependent on the importance of the endowment fund in

the sponsor's overall budget picture

Endowment risk tolerance is not dictated by the relationship between the current income

requirement and maintenance of purchasing power, whereas this is a crucial factor for

foundations

Foundation risk tolerance is dependent on the importance of foundation funds in the sponsor's

overall budget picture, while endowment risk tolerance is dependent on the time horizon of the

Private foundations are required to have a minimum spending rate whereas

endowments rarely have minimum spending rates

Endowments are required to have a minimum spending rate whereas private foundations rarely

have minimum spending rates

An endowment's spending rule will have less of an effect on liquidity requirements than a

foundation's liquidity requirement due to a minimum spending rate

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Private foundation investment income is taxable, whereas other foundations and endowments are not

The following statements concern differences between the investment policy statement for an institution and that for an individual Which

of these statements is least accurate? The institutional investment policy statement:

has four main steps planning, estimation, execution, and feedback while the

individual investment policy statement has three

may have asset structure and liquidity requirements that are driven by the institution's liability

Which of the following CORRECTLY describes the primary source of invested funds to meet funding requirements for anendowment fund and an investment company?

Endowment Fund Investment Company

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A defined benefit pension plan decides to index their benefits to inflation Meanwhile, the labor force has increased in

productivity and profits have soared Which of the following best describes the changes to their liability-mimicking portfolio?The liability-mimicking portfolio should have:

more equities and more nominal bonds

more equities and more real return bonds

fewer equities and more real return bonds

Explanation

If the pension plan decides to index their benefits to inflation, more real return (inflation-indexed) bonds should be added tohedge the benefits If the labor force becomes more productive, wages will increase due to this real growth This real growth isrelated to economic growth and is best hedged by equities

The return objectives for a life insurance company can be broken into two segments, the fixed-income and the surplus segments Whichreturn objectives are mostly associated with each segment, respectively?

Yield maximization and spread management

Spread management and maximizing yield

Spread management and capital gains

Explanation

The return objectives for a life insurance company have mainly been associated with earning a competitive return that helps increase thespread between assets and liabilities The surplus portfolio, however, has growth in the surplus as its main return objective, which willhappen via capital gains

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World Wide Telecom (WWT), a troubled internet service provider recently filed Chapter 11 bankruptcy after seven

unsuccessful years of operations It was a plan sponsor in WWT Pension Plan for the benefit of its employees The followinginformation was available at the time of its bankruptcy filing:

Employees: 500

Plan assets: $15 million

Plan liabilities: $19 million

Average age of workforce: 30

1% of plan assets are being paid out to retirees and no more participants are expected to retire over the next five years.Due to the company's financial condition, the plan was under-funded

The duration of the plan liabilities is 25 years

Inflation is expected to be approximately 1% over the next five years

The bankruptcy trustee appointed Eric Geecu, CFA, as the portfolio manager overseeing the WWT Pension Plan to developguidelines for its investment policy statement and the ultimate distribution of the proceeds of the plan upon fully funded status.Geecu believes that fully funded status could be achieved within the next five years, assuming the plan earns an expected rate

of return in excess of its plan liabilities The plan liabilities are expected to increase at the rate of inflation

In developing an investment policy statement (IPS) for WWT Pension Plan, which constraints should Geecu consider?

A short time horizon, low liquidity needs, with assets managed according to the

"prudent expert" rule

A long time horizon, unique circumstances associated with the Chapter 11 bankruptcy, with

no current taxes to be considered for the pension plan

The pension plan is governed under ERISA, unique circumstances that the plan cannot

provide any funds to meet the plan's underfunded status, and a long time horizon

Explanation

Time horizon - The time horizon for this plan is short Since the plan sponsor, WWT, is currently in bankruptcy and would not

be considered a going concern, it cannot provide any funds to minimize the plan deficit Since there is only a 5-year timehorizon for the plan coupled with the uncertainty on the disposition of available funds in five years, the primary goal of this plan

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ᅚ A)

ᅞ B)

ᅞ C)

is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon Five years

is a short time frame to achieve these goals Any IPS developed must consider capital preservation first and then consider atotal return approach to preserve the plan from the effects of inflation

Liquidity - The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paidout and no more employees are expected to retire over the next five years The average age of the workforce is 30 and youngand will not require any distributions until the expected termination upon its fully funded status Therefore, the plan only has toprovide for its current retirees at a rate of 1% per year

Laws and regulations - This pension plan is governed by ERISA and must adhere to the prudent expert rule As such,diversification is necessary to minimize the risk of large losses to the plan and capital preservation

Taxes - There are none to be considered for the pension plan However, upon the distribution of the plan assets after fiveyears, there could be a tax impact on the plan participants Tax counsel is advised here for the plan and its participants to also

do some tax planning for the ultimate distribution of the proceeds of the plan in five years

Unique circumstances - WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing and, therefore, cannot provide anyfunds to meet the plan's underfunded status The plan must also consider the administration of the distribution of the proceeds

of the plan after five years to its plan participants Should the underfunded status remain (assuming a higher than expectedlevel of benefits are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) specialpolicies and procedures may need to be considered at the time of the distribution of the plan assets

In developing an IPS for WWT Pension Plan, what must Geecu consider with respect to the return objective and risk tolerance for theplan?

Return requirement = 6.84%, risk tolerance = low or below average

Return requirement = 7.33%, risk tolerance = low to average

Return requirement = 7.89%, risk tolerance = moderate to high

Explanation

Return requirement - The plan must consider the preservation of capital as its primary objective over the 5-year time horizon.The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan deficit of $4 million (planasset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation

PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84%

Rate of return to achieve fully funded status = 4.84%

Plus: benefits paid out to retirees = 1.00%

Plus: expected inflation rate = 1.00%

Equals the return requirement = 6.84%

Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could beinvested at a required rate to achieve fully funded status in five years Thus, the computation to achieve the rate of return is:(Future Value ¸ Present Value) (1/term) or using a financial calculator =4.84% The result of this calculation is 4.84 percent.Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1percent to arrive at the return requirement of 6.84 percent

This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees andpreserving the capital from the effects of inflation

Risk Tolerance - The risk tolerance for the pension plan is low or below average The primary objective of the plan is to

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Based on the information presented in the case above and the IPS, which of the following portfolios would be the most

appropriate for WWT:

Expected Return Portfolio A Portfolio B Portfolio C

corporate bonds in the 5-year time horizon in order to meet the termination requirements of the plan Its Sharpe ratio is at the mid-point ofall the portfolio selections offering a moderate level of excess returns for its risk level

Portfolio A is inappropriate because of the higher concentration in stocks (60%) and low concentration in bonds (30%) Given the low risktolerance and the short time horizon, this portfolio would be subject to high levels of market risk because of its high stock allocation Since the primary goal is capital preservation, the high exposure to stocks makes this portfolio selection risky because of the lack of

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long-One difference between the asset liability management techniques between a life and nonlife insurance company is liability:

payment amounts are not known for the life insurance company

payment amounts are known for the nonlife insurance company

payment amounts are known for the life insurance company

Explanation

The liability payment amounts for the life insurance company are known, whereas they are not known for the nonlife insurance company

Pension fund risk tolerance is increased by a young workforce and:

high retired-lives proportion

low retired-lives proportion

high plan sponsor leverage

Explanation

Pension fund risk tolerance is increased by having a young workforce and a small proportion of retired lives Both of the other

combinations with a young workforce will tend to decrease risk tolerance

Which of the following statements regarding the focus of a liability-mimicking versus an asset-only portfolio of pension plans isCORRECT? The liability-mimicking portfolio will have a:

low correlation with the liabilities and the asset-only approach will focus on

investments with a low correlation to assets

high correlation with the liabilities and the asset-only approach will focus on

investments with a high correlation to assets

high correlation with the liabilities and the asset-only approach will focus on

investments with a low correlation to assets

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Which of the following statements are correct regarding a participant-directed defined contribution plan?

Statement 1: The plan should be responsible for establishing and revising the interest rate for plan loans to participants.

Statement 2: The plan should provide criteria for manager/fund selection, termination and replacement.

Instead of stating objectives and constraints (as in defined benefit plans), the purpose of a participant-directed defined

contribution investment policy statement is to provide a governing document that describes the investment strategies andalternatives available to plan participants Some defined contribution plans allow plan participants to take out loans against theamount they contributed

Bob Monarch, CFA, has been managing portfolios for individuals for about 10 years It started out as a second job, but about 5years ago he left his full-time position to manage the portfolios as his sole occupation His clients are largely retired or personsnear retirement who would be considered to be conservative investors

In the last two years, Monarch has been sending out resumes to institutional investment firms of various types in the hopes ofbecoming a full-time manager of a single fund Recently, he has been invited to two interviews for the position of portfoliomanager The first interview he schedules is with an investment company for a position as manager of their mid-cap growthequity mutual fund

Monarch's second interview will be with Starling College (Starling) for the position of endowment manager The endowmentfund has been highly correlated with the S&P 500 in growth and income, but with a beta of about 0.6 The endowment follows

a "socially conscious" investment policy The current spending rate is set at 3% annually, the minimum needed to supportStarling's operating budget This is unlikely to change To provide for real growth of the principal, the fund's moderatelyaggressive return target is also unlikely to be altered

Both the mutual fund and the endowment have assets in the tens-of-millions of dollars, and each is offering a roughly

equivalent salary and benefits package Consequently, Monarch feels he would be happy with either position As he preparesfor his interviews, he compares the portfolio management approach he currently employs to what would be appropriate ineither of the two prospective positions He creates the following template and begins to summarize his thoughts:

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ᅞ A)

ᅚ B)

ᅞ C)

Current Clients vs Investment Co & Endowment Fund

Risk Objective

Time Horizon

Taxes

Liquidity

Legal & Regulatory

Unique Constraints Focus on Single Asset Class Socially Conscious

After work that evening, Monarch calls Antonia Linn, a friend who is an emerging markets debt analyst for a large investmentbank He wants her advice on the two positions he is considering, and hopes she can give him some helpful interviewing tips.During the course of their discussion, Linn asks Monarch to distinguish between endowments and foundations They disagree

on the issues of taxation and the allowable functions foundations and endowments may undertake

Monarch states that "while both are tax-exempt entities, endowments are generally organized to provide ongoing budgetarysupport for the operations of a specific entity, such as a university or some other charity Foundations are typically formed forgrant-making purposes, but can also be created to provide perpetual support for a specific charitable organization."

Linn responds: "Well, I know that's not my field, but as I understand it, foundations are taxable while endowments are not Inaddition, I think that foundations can make grants, but can't be set up to provide permanent support You'd better be sure toknow the distinctions before your interviews."

Compared to the risk tolerance of Monarch's current clients, the risk tolerance of the investment company and endowmentfund would be:

Investment Co Endowment

Compared to the average time horizon of his current clients, the time horizon of the investment company and endowment fundwill be:

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Both the endowment and investment company would have longer horizons than Monarch's current clients Institutions

generally have longer horizons than individuals, and this is especially true given that Monarch's clients are retired or nearretirement (Study Session 6, LOS 14.i)

Which of these situations (the investment company or the endowment fund), would have the fewest tax considerations?The investment company

There is no clear answer

The endowment fund

Explanation

An endowment fund does not have to consider taxes Although, an investment company manager is judged primarily on thetotal pretax return, the public is paying increasing attention to the tax implications of funds with high turnover rates (StudySession 6, LOS 14.i)

Which of these situations (the investment company or the endowment), would require the most attention to generating apositive alpha?

The investment company

consciousness Thus, alpha would not be the primary focus (Study Session 6, LOS 14.l)

With respect to the statements made by Monarch and Linn comparing foundations and endowments:

Monarch is incorrect about taxes and correct about functions; Linn is correct

about taxes and incorrect about functions

Monarch is incorrect about taxes and incorrect about functions; Linn is correct about

taxes and correct about functions

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Monarch is correct about taxes and correct about functions; Linn is incorrect about

taxes and incorrect about functions

Explanation

Foundations are subject to excise taxes between1-2% on net investment income Any unrelated business income is exposed

to regular corporate tax rates In addition to grant-making, foundations can be primary sources of ongoing funding for

charitable programs (Study Session 6, LOS 14.i)

Monarch thinks he might be questioned about the predictive power of an investment manager's past performance Which ofthe following factors is least likely to help when projecting how well a manager will do in the future is:

what time frame was used to measure performance

the manager's nominal return

whether the performance was evaluated relative to a style benchmark

Explanation

The nominal return itself provides limited information for gauging a manager's future success Risk-adjusted returns andreturns relative to a style or index benchmark are more useful Other important factors to consider are the investment process,who the investment decision-makers are, the time frame, the presence of dependable staff, the size of the portfolio, and theconsistency of the performance (Study Session 12, LOS 24.u)

Which of the following statements regarding foundations is most accurate?

Grants from company-sponsored foundations must be made without regard to

the sponsoring company's business interest

Independent foundations receive their funds from an individual, family, or group

An operating foundation is generally funded by the organization it is intended to

support

Explanation

Company executives usually dominate the board of trustees for a company-sponsored foundation, which may use grants tofurther corporate interest A fund owned and funded by the organization it is intended to support is called an endowment, not afoundation

The liquidity requirement of a pension plan is directly related to and increased by a:

low proportion of retired lives

high proportion of retired lives

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When grading Musch's paper, Dr Wolfe should:

disagree with Statement 1, but agree with Statement 2

disagree with Statement 1 and Statement 2

agree with Statement 1 and Statement 2

Explanation

When grading the paper, Dr Wolfe should agree with both of Musch's statements Musch has indirectly hit on the two keydifferences between a mutual fund (investment company) and other types of institutional investors such as pension funds Thepension plan uses its own assets to meet various funding requirements while the mutual fund invests money pooled frominvestors based on advertised objectives and constraints It would be relatively easy for the pension fund to have a meetingand decide to adjust its asset allocation, while the growth mutual fund, which advertises its objectives in a prospectus wouldlikely have to change the prospectus that governed the objective of the fund and possibly hold a shareholder proxy vote.Statement 2 is also correct The mutual fund invests funds on behalf of other investors, while the pension fund is part of acompany Since the pension is an investor itself, the pension fund could invest in the mutual fund, but the mutual fund couldnot invest in the pension

One difference between the asset liability management techniques between a life and nonlife insurance company is liability payment:

amounts are known for the nonlife insurance company

amounts are unknown for the nonlife insurance company

timing is known with certainty for the nonlife insurance company

Explanation

Liability payment amounts are unknown for the nonlife insurance company

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as owner of the company, Mr Findlay, to liquidate a large block of your Impact Product holdings." After further discussion, theymove on to discussing cash balance plans Harbal reports, "Unlike regular pension plans, cash balance plans can never beunder funded because the cash balance reflects the actual amount put away for employees." With regard to their statementsabout ESOPs and cash balance plans:

Beery's statement is correct; Harbal's statement is correct

Beery's statement is incorrect; Harbal's statement is incorrect

Beery's statement is correct; Harbal's statement is incorrect

Explanation

An ESOP is a type of defined-contribution plan that allows employees to purchase company stock, sometimes at a discount tothe market price Beery's statement is correct Occasionally, an ESOP will purchase a large block of the firm's stock directlyfrom a large stockholder (such as an owner who wants to liquidate a holding) The stock is then purchased at regular intervals

by plan beneficiaries Harbal's statement is incorrect The account balance shown on a cash balance plan's statement to abeneficiary is calculated on paper only based on a participant's credits It is possible for a company not to fund its obligation,resulting in an underfunded cash balance plan

Raul Garcia, CFA, works for Enterprise Insurance Company (hereafter referred to as the "Enterprise") Enterprise offers anumber of products including whole, term, universal, and variable life policies The retail line is Enterprise 's mainstay; the firmdoes only a small amount of group life business and corporate-owned life insurance to fund executive deferred compensationplans Most of the policies Enterprise issues are for face amounts less than $10 million, although they do occasionally

participate in underwriting large policies for the high net worth market To limit risk, a reinsurance syndicate is used for policies

in excess of $25 million Enterprise has always received the highest rating from A M Best and Moodys

Garcia has been asked to review the data in Tables A and B below He knows that Enterprise uses a traditional approach formanaging its Policy-Holder Reserves (PHR) portfolio He also realizes that the interest rate yield curve is becoming steeper.Short-term interest rates have been trending downward while long-term rates have been increasing Furthermore, the stockmarket appears to be in a bull phase that will last into the foreseeable future

Table A Changes in Assets and Liabilities (data in millions)

Prior Year-End Current Year-End

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Asset Class Portfolio I Portfolio II Portfolio III Portfolio IV

Burns replies, "I believe that disintermediation is exacerbated when assets decline at a greater rate than liabilities during highinterest rate periods Let's check on this issue and get together again later today."

The change in Enterprise's surplus as shown in Table A is a:

negative sign because it means that the firm has mismatched its liabilities and

assets

positive sign because it means the firm can take more risk to generate a higher return

positive sign because it means the firm has more liquidity

Explanation

A large surplus is a good thing for an insurance company Even if it was achieved using risky methods, once it is there, it ispositive for the firm The firm can assume more risk with a larger surplus, and this may lead to higher return and a reduction inthe overall risk of the firm (Study Session 6, LOS 14.i)

The change in the relative durations of the PHR and Enterprise's liabilities is a:

negative sign because risk has increased

positive sign because it means the firm is benefiting from yield curve changes and the

stock market

negative sign because it means the firm is not benefiting from yield curve changes

and the stock market

Explanation

Enterprise's goal should be to match the durations of the PHR and liabilities The increased divergence of the durations meansthat Enterprise has higher interest rate risk (Study Session 6, LOS 14.i)

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and liabilities

RegulatoryrestrictionsThe durations of PHR

and liabilities Reinvestment risk

Explanation

The duration of policy-holder reserves (PHR) has increased, while the duration of the liabilities has deceased The investment

in short-term bonds would help address this concern by lowering the duration of the PHR to better match that of the liabilities.Regulations may prevent Enterprise from investing in low-grade bonds if the bonds introduce too much default risk into theportfolio Although investing in low-grade, high-yield bonds could enhance surplus returns, additional surplus growth shouldnot be a primary concern at this time Reinvestment risk is a concern of life insurance companies but the main concernEnterprise has at the moment regarding a decrease in interest rates and a shorter duration of liabilities compared to theirassets is disintermediation and not reinvestment risk (Study Session 6, LOS 14.i)

Based on the information above, rank the following items from most important to least important for Enterprise to address:changes in the surplus, relative durations of the PHR and liabilities, and the yield curve

Surplus, yield curve, relative durations

Surplus, relative durations, yield curve

Relative durations, surplus, yield curve

Portfolio III is most appropriate; Portfolio I is least appropriate

Portfolio II is most appropriate; Portfolio III is least appropriate

Portfolio I is most appropriate; Portfolio IV is least appropriate

Explanation

Portfolio III is the best choice Enterprise can be aggressive with its surplus and diversify away some of its interest rate risk

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Which of the following best evaluates the accuracy of Garcia's and Burn's statements about disintermediation?

Garcia is incorrect; Burns is correct

Garcia is correct; Burns is incorrect

Garcia is incorrect; Burns is incorrect

Explanation

Disintermediation occurs in high interest rate environments, prompting large numbers of policy loans or surrenders

Policyholders take proceeds from lower-rate policy loans or their surrender values and reinvest at more favorable rates.During high-rate environments liability durations decrease dramatically and liquidity needs rise To the extent that assetsdecline at a greater rate than liabilities in an increasing interest rate environment, disintermediation will be exacerbated (StudySession 6, LOS 14.i)

Helen Smith, CFA, has been assigned the portfolio management responsibilities for her firm's first institutional investor, BranchIndustries Defined Benefit Pension Plan (hereafter referred to as the "Plan") To date, Smith's firm has managed money onlyfor high net worth individuals In addition to her portfolio management duties, Smith has been delegated the task of formulatingthe investment policy statement (IPS) for the Plan

Branch Industries manufactures tiny transformers and circuitry used in small electrical appliances, and components for carsand trucks Silver is a small, but critical, input to the production process, and Branch uses a reliable supplier Branch's saleshave grown steadily for the past three years despite a rather tepid economic recovery fostered by modest tax cuts andaggressive expansion of the money supply It appears likely that Federal Reserve policy will remain accommodative, withcontinued low interest rates Therefore Branch's five-year sales forecast is very optimistic Branch's profit margins are

projected to be in line with its competitors, but the firm is carrying significantly more debt in its capital structure than

comparable companies

Smith has determined the following about the Plan:

The average employee age is 45.5 years, and the active-to-retired participant ratio is high

The Plan should be considered ongoing, and it has a moderate surplus

Employees are eligible for retirement at age 62 There are no provisions for lump-sum distributions or early retirement.The discount rate for the projected benefit obligation (PBO) is 10%

The expected return on plan assets is 10 percent

Smith decides she needs to review the terminology, accounting, and other factors affecting the Plan's funding status Below isher brief synopsis of relevant terms:

Exhibit A: Pension Terminology

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Net Pension Cost Income statement expense to be recognized for a specific year.

Funded (Surplus) Status Market value of plan assets less the present value of future liabilities.

Smith recalls that the Pension Committee wishes to minimize the volatility of future contributions They also expressed concernthat the discount rate and expected return on plan assets might need modification She decides to explore these issues furtherbefore finishing the IPS or developing an asset allocation recommendation for the portfolio

Which of the following best explains two constraints that differ between individuals and pension funds and the way they differ?Legal and tax considerations: pensions must follow the Employee Retirement

Income Security Act (ERISA) whereas individuals can usually invest as they

please; pensions are tax-exempt investors whereas individuals pay taxes

Legal and time horizon considerations: pensions must follow the Employee Retirement

Income Security Act (ERISA) whereas individuals can usually invest as they please;

pensions have finite lives whereas individuals do not

Liquidity and time horizon considerations: pensions always have a greater need for

liquidity than individual investors; pensions have infinite lives whereas individuals do

not

Explanation

Pensions must operate under a plethora of regulatory burdens, such as ERISA Individual investors normally are not subject toonerous legal considerations concerning their investment decisions Pension funds are tax exempt, but most individuals mustpay taxes (Study Session 6, LOS 14.b)

Regarding the pension terminology in Exhibit A, the definition of:

ABO is correct; PBO is correct; funded status is incorrect

ABO is incorrect; PBO is correct; funded status is correct

ABO is incorrect; PBO is incorrect; funded status is correct

Explanation

A plan's ABO dictates what is owed to participants in a terminating plan The pension benefit obligation (PBO) is the obligationrequired of a pension plan for a company considered a going concern Funded status is the relationship between the present(market) value of plan assets and the present value of plan liabilities (Study Session 6, LOS 14.a)

Future pension contributions required will be directly affected by:

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the expected return on existing plan assets and pension default expectations.

prior expected return estimates and pension expense requirements

Considering the characteristics of Branch Industries and the Plan, which of the following statements best describes the ability

of the pension plan to take risk?

Average ability to take risk

Below average ability to take risk

Above-average ability to take risk

Explanation

Overall, the data Smith has gathered so far indicate an average tolerance for risk The plan surplus indicates that the presentvalue of plan liabilities is more than covered by the present value of plan assets Pension plans with restrictive plan features,such as no early retirement or lump-sum distribution provisions increases the duration of the liabilities which, in turn, allows for

a higher risk tolerance The workforce is young; a high active to retired lives ratio indicates a large portion of the workforce isstill working while only a small portion of beneficiaries is receiving plan benefit payments All of these factors indicate anabove-average ability to take risk However, if the Pension Committee were to decrease the discount rate, the PBO would riseand the surplus could disappear Also, a spike in commodity prices (silver required and only one supplier) and/or the cyclicality

of the auto industry could adversely affect Branch's sales and profit margins Hence, Branch's ability to make contributions ifthe economy slumps, could be compromised In addition, Branch is more heavily leveraged than its competitors This couldalso impact its ability to make timely contributions in an economic downturn These factors imply less ability to take risk,especially in light of the Pension Committee's expressed desire to control the volatility of contributions (Study Session 6, LOS14.c)

Which of the following factors should NOT affect a pension plan's ability and/or willingness to take risk?

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To maximize the sponsor's ability to make pension contributions and meet the Pension Committee's desire to manage

contribution volatility, Smith should give the most consideration to the correlation between the sponsor's:

operating profitability and Plan termination potential

net income and the Plan's ABO

operating profitability and Plan asset returns

Explanation

The correlation between the sponsor's operating profitability and plan asset returns comes directly to bear on the firm'srequired contributions and its ability to make them When operating profitability and plan asset returns are high, the probability

of having to make greater than average contributions is low, but at a time when the sponsor is most able to make a

contribution Alternatively, when operating profitability and plan asset returns are low, the probability of having to makecontributions is high, but at a time when the sponsor may have difficulty making a contribution Minimizing the correlationbetween the sponsor's operating profitability and plan asset returns will maximize the probability that the sponsor will be able

to make contributions when required to do so (Study Session 6, LOS 14.c)

Lakeland Life Insurance Company is a U.S based underwriter of life insurance policies doing business in 23 states In the past

5 years the company has completely revamped its product offerings, going from a focus on whole life policies to floating ratereferred variable and universal life policies The average duration of the company's insurance liabilities is eight years

Lakeland targets a 1.5% spread on investment assets over liabilities The current expected nominal actuarial return is 5%(based on current capital market conditions), but management expects the rate environment to get more volatile in the comingmonths

The company has segmented its investments into two portfolios: a income portfolio and a surplus portfolio The income portfolio is invested primarily in long-term corporate and U.S Treasury bonds The surplus portfolio is currentlyinvested in the common and preferred stock of large, well-known U.S companies The surplus portfolio has a dividend yield of3% Management expects equity markets to earn 12% per year in the long term

fixed-The appropriate return objective for the fixed-income portfolio is to earn a return:

sufficient to provide a spread of 1.5% over the promised rate on the company's

variable rate insurance products while maintaining an average duration of 8

years, in order to fund liabilities

of 6.5% while maintaining an average duration of 8 years in order to fund insurance

liabilities

of 18.5% sufficient to fund long-term expansion in insurance volume and fund

insurance liabilities through a total return approach

Explanation

The company has segmented its investment portfolio; the purpose of the fixed-income segment is to fund insurance liabilities.The return objective should focus on providing the target spread over policy costs, which float with changes in interest rates

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"of 12% sufficient to fund long-term expansion in insurance volume by investing in growth-oriented securities, primarily equity."

A total return approach is not appropriate for the fixed-income or the surplus portfolio

The appropriate risk tolerance for the surplus portfolio:

is lower than that of the fixed-income portfolio, to guard against loss of principal and

maintain a constant income stream, in order to maintain public confidence in the

company's ability, in its role as a fiduciary, to fund policyholder liabilities

is higher than that of the fixed-income portfolio, because the funds should be used to support

long-term growth in insurance volume

is the same as that of the fixed-income portfolio While the portfolios are nominally separated

for regulatory purposes, they should actually be managed as a single portfolio, because funds

from each can be used to meet both goals of long-term growth and current funding of

liabilities

Explanation

A lower risk tolerance is appropriate for the fixed-income portfolio, on the other hand, to "guard against loss of principal and maintain aconstant income stream, in order to maintain public confidence in the company's ability, in its role as a fiduciary, to fund policyholderliabilities." Interest rate volatility over the short-term is not a primary concern of the surplus portfolio The portfolios are "nominallyseparated," but not "for regulatory purposes;" each should have its own investment policy statement

The appropriate time horizon constraint for the surplus portfolio:

is shorter than that of the fixed-income portfolio, because policies such as universal

and variable life have shorter effective maturities than traditional life insurance

products

is longer than that of the fixed-income portfolio, because the purpose of the surplus portfolio is

to support long-term growth in new lines of business

is the same as that of the fixed-income portfolio While the portfolios are nominally separated

for regulatory purposes, they should actually be managed as a single portfolio, because funds

from each can be used to meet both goals of long-term growth and current funding of

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Which of the following is NOT appropriate to include as tax or regulatory constraints in the company's Investment Policy Statement?

The regulatory constraint should include the recognition that, by law, common stock

holdings are typically limited to a certain percentage of assets

The regulatory constraint should include the recognition that, for U.S life insurance

companies, state law prevails over federal law

The regulatory constraint should include a statement that the company is subject to the

Prudent Expert Rule

Explanation

This statement is not appropriate in the Investment Policy Statement; unlike pension funds, insurance companies are subject to thePrudent Investor Rule

Which of the following statements regarding defined benefit and defined contribution pension plans is least accurate?

The liability to a defined contribution plan sponsor is the current plan contribution

requirement

Promised benefits under a defined benefit plan are paid to plan participants at retirement and

represent a liability to the plan sponsor

The risk and return of defined benefit pension fund investments is borne by the plan

participants

Explanation

As long as a pension sponsor is solvent, the performance of the fund's investments has no impact on the benefits promised to theemployees covered by the plan The risk and return characteristics of the assets of a defined benefit pension fund are borne by the plansponsor

The Carraway Endowment Fund was originally established to contribute to the support of the operations of Carraway MedicalCenter in the United States The Carraway Fund currently has assets of $50 million, and the fund's asset allocation at the end

of 2014 is shown in the table below In mid-2015, the Carraway Medical Center opened research facilities in Germany andSingapore As a result of the expansion, the annual spending rate of the Carraway Fund was increased from 3.5% to 5.2% oftotal assets, and 30% of the fund's annual payout was allocated to the new facilities Support for the new operations must beprovided in local currencies Inflation is expected to be 3.0% during each of the next several years

Carraway Endowment Fund Asset Allocation, 2014

Asset Class Current Allocation (%, US$) Expected Returns (%)

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Which of the following most appropriately addresses the Carraway Fund's allocation to cash? Endowment funds:

typically have low liquidity needs Therefore, a 2.0% allocation to cash is excessive

typically have low liquidity needs Therefore, a 2.0% allocation to cash should be sufficient to

cover operating expenses

often have high liquidity needs Therefore, a 10% allocation to cash may be necessary to

cover operating expenses and unexpected liquidity needs

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Which of the following most appropriately addresses the funds allocation to international bonds? The Carraway Fund's allocation tointernational bonds is:

too low A 25-30% allocation to international bonds is more appropriate

too low A 10-15% allocation to international bonds is more appropriate

appropriate There is no reason to include an allocation to international bonds

Explanation

Assuming an approximate 35% total allocation to fixed income investments, the fund should divide this allocation between U.S andinternational bonds The increased allocation to international bonds is also supported by:

1 the higher yield

2 the endowment will need non U.S dollar denominated currency to fund the newly established non U.S operations

3 the diversification gains attributable to international diversification

Which of the following most appropriately addresses the funds allocation to U.S bonds? The Carraway Fund's allocation to U.S bonds is:

too high A 20-25% allocation to U.S bonds is more appropriate

too low A 70% allocation to U.S bonds is more appropriate

The firm will have a high probability of making pension payments when its

ability to fund those payments is low

A positive long-run impact on firm valuation, and a more stable pension surplus

The firm will have a high probability of making pension payments when its ability to

fund those payments is high

Explanation

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Which of the following would NOT be typically included in the asset-only approach portfolio of a pension?

The potential effect of a pension plan policy that positively impacts a plan surplus is a:

high discount rate, low plan feature flexibility, and low liquidity requirements

high discount rate, plenty of plan feature flexibility, and high liquidity requirements

low discount rate, high retired-lives portion, and high liquidity

Correlation of Assets

with Liabilities

Correlation of Assetswith Firm Operations

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Ranjana Clarkson, CFA, has just been hired by First National American (FNA), a small Midwestern U.S bank FNA is located

in a town with a population of 50,000, adjacent to a large U.S Army installation Other than the military base, the economy ofthe area is primarily agricultural Beef cattle, wheat, and corn are the mainstay products

Clarkson, originally from India, is married to a career military officer, hence she must relocate every few years Despite herlack of banking experience, her supervisor was impressed with Clarkson's investment expertise and prior work as an equityanalyst and portfolio manager He was anxious to hire someone with her credentials - a rarity in such a small community.Clarkson feels confident that she can make the transition to banking, but knows she needs to learn a lot more about thespecifics of the industry, particularly with regard to how their securities portfolios are managed

As part of her review process, Clarkson begins to assemble a notebook with pertinent information Her progress so far isdetailed below:

Figure 1: Objectives and Constraints

1 Manage risk relative to liabilities

2 Earn a positive interest spread

3 Contain liquid assets

4 Short to intermediate term time horizon

5 Highly regulated legal environment

Invest equal amounts on both the short and long ends of the maturity spectrum.

Bullet Strategy Concentrates the maturities of the bonds in the portfolio around a single point on the yield

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The lowest priority use of a bank's funds is for:

liquidity for depositor withdrawals

With respect to the descriptions of the three portfolio management approaches detailed in Figure Two of Clarkson's notebook:ladder is incorrect; barbell is incorrect; bullet is correct

ladder is incorrect; barbell is incorrect; bullet is incorrect

ladder is incorrect; barbell is correct; bullet is correct

Explanation

The ladder strategy approach staggers investments with equal amounts invested throughout the maturity spectrum Over time,periodic reinvestment of maturing securities is required With a barbell approach, investments are made both on the short andlong ends of the maturity spectrum; weighted more heavily on one end or the other depending upon the manager's interestrate outlook A bullet strategy concentrates the maturities of the bonds in the portfolio around a single point on the yield curve.(Study Session 9, LOS 20.k)

To make an aggressive bet on the interest rate environment that Clarkson anticipates, she should use a:

barbell approach and under-weight investments in short-term securities

bullet strategy and over-weight investments in short-term securities

ladder approach and over-weight investments in short-term securities

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manager's interest rate outlook When rates are expected to rise (as Clarkson anticipates), short-term securities can be weighted using a bullet strategy which concentrates securities in one area on the yield curve (Study Session 9, LOS 20.k)

over-Assessing the capital risk position is relevant to the investment management process at a bank because it indicates theappropriate amount of:

liquidity weighted assets

credit weighted assets

risk weighted assets

With regard to their statements about Genetron's pension plan:

Pyle's statement is correct; DeGroot's statement is incorrect

Pyle's statement is incorrect; DeGroot's statement is incorrect

Pyle's statement is correct; DeGroot's statement is correct

Explanation

With 70% of Genentron's pension assets allocated to a health care fund, the correlation between the firm's pension assets andprofits is likely to be strong Pyle's statement is correct - if the health care industry has strong performance, both Genetron'sprofits and the performance of the pension plan are likely to be high When a firm is generating high profits simultaneously withhigh returns, the probability of the firm having to make a pension contribution is low, and if a contribution is made, the amount

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Gina Manley, CFA, is a pension fund manager for Brooke and Associates She manages the pension fund accounts forseveral small and medium-sized firms.

Company owner Herb Brooke has tasked Manley with reviewing the firm's asset-allocation policy In the past, Brooke andAssociates included large-company international stocks and large-company domestic stocks as part of the same asset classbecause they have similar risk and return properties, even though they have a low (0.4) correlation with each other Venturecapital was included as part of the small-company stock asset class because it has a high correlation (above 0.7) with small-company stocks, even though the risk of venture capital investments is far greater than the risk of small company stocks

As part of her portfolio management duties, Manley has recently taken over two pension accounts from other fund managers.The first account is the Crandall Company pension account In reviewing the investment policy for Crandall, she finds astatement that "the fund shall not directly use equity futures, nor shall it hire any outside money manager that uses equityfutures as part of its investment strategy in managing the fund's assets."

The second new account Manley has recently acquired is the Cooper Company pension fund The fund currently has a 70%allocation in equities, including 10% in Cooper stock, with the rest in bonds The plan is currently underfunded Manley

believes the fund's equity portfolio, including the Cooper stock, will provide an annualized return of 8% over the next five years.The fund's long-term, investment-grade bonds should provide a 4% return

Manley is also working with a new client, Chapman Inc., to set up a new pension fund Manley's discussions so far have beendirectly with the owner, David Chapman Manley has laid out for Chapman the advantages and disadvantages of defined-benefit plans and defined-contribution plans She tells Chapman about the following characteristics of defined-contributionplans:

The employee makes regular contributions to the fund

Benefits are based on formulas relating to employee earnings or length of service

The employee bears all of the investment risk

The employer has no financial obligation beyond making contributions

Chapman is comfortable with Brooke and Associates, likes Manley's work, and he decides to set up a defined benefit planinstead of a defined contribution plan In the process of gathering data, Manley discovers the following information aboutChapman Inc.:

The company is five years old

Most of Chapman's employees graduated from college less than 10 years ago

Stock options represent a significant portion of most employees' compensation

The median annual salary of Chapman employees is $65,000

David Chapman and two of his vice presidents plan to retire within the next two years

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Which of the following is least likely to be an investment constraint for the Chapman pension fund?

Regarding the Cooper Company pension plan, Manley's best course of action is to:

lower the fund's equity allocation, but not sell the Cooper stock, as such a

large sale would drive the price down

increase the allocation to equities because risk diminishes over time

lower the fund's equity allocation by selling the Cooper stock

Explanation

Manley's fiduciary duty is to the beneficiaries of the plan, not the company While holding the Cooper stock may benefit theshareholders, it is unlikely to benefit the employees The company stock provides an undiversified position that is correlatedwith the employees' human capital and should be sold An equity allocation of 70% would be considered high for most pensionplans (the average is around 50%), so while diversifying the bond holdings may be a good move, maintaining the equityweighting is not Some thought could be given to the fact that the plan is underfunded, and that the plan needs growth In thissituation, the plan also needs to protect the existing assets from too much risk so that the underfunding situation is not

exacerbated In this case, reducing the equity weight to an average level and increasing contributions would be the bestcourse of action (Study Session 6, LOS 14.f)

Which of the following is the best justification for Crandall Company's futures policy?

Futures are used mainly for speculative purposes

The use of futures is inconsistent with the Prudent Expert Rule of ERISA

Futures are used to manage short-term risks, and the fund should be concerned with

long-term risks

Explanation

Most futures transactions are used to manage short-term risks and those transactions might not impact long-term risks.Futures are often used to hedge equity holdings, and nothing in the Prudent Expert Rule would prohibit their use under theproper circumstances The fund's bond holdings are irrelevant, as long as there are equity holdings for which futures could beused to hedge risk (Study Session 6, LOS 14.j)

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Which of Manley's statements regarding defined-contribution plans is least accurate?

Benefits are based on formulas relating to employee earnings or length of

service

The employer has no financial obligation beyond making contributions to the plan

The employee makes regular contributions to the fund

Explanation

In a defined-contribution plan, the employee typically makes regular contributions to a fund that the company matches

according to some formula, such as a percentage of current pay The employee bears all of the investment risk in a definedcontribution plan, and the employer has no financial obligation beyond making regular contributions on behalf of qualifyingemployees (Study Session 6, LOS 14.a)

Regarding its asset classes, Brooke and Associates' best course of action is to:

separate international stocks as a unique asset class, but leave venture capital

in the small-company stock class

separate venture capital as a unique asset class, but leave international stocks in the

large-company stock class

separate both venture capital and international stocks as unique asset classes

Explanation

It is easier to optimize portfolios using asset classes with different risk characteristics and low correlation with other assetclasses None of the answers are wrong, but separating international stocks and venture capital into their own classes allowsfor the most precise optimization (Study Session 6, LOS 14.f)

Which of the following represents the most appropriate asset allocation for Chapman's pension fund?

40% large-cap stocks, 30% high-yield bonds, 20% investment-grade bonds,

10% real estate

60% large-cap stocks, 30% small-cap stocks, 10% foreign stocks

40% investment-grade bonds, 30% small-cap stocks, 20% large-cap stocks, 10%

venture capital

Explanation

No matter how young the work force, an all-equity investment mix is inappropriate for a pension fund, which is always going tohave at least a slight need for liquidity (particularly when the chairman and his lieutenants retire), and must be managed insuch a way as to reduce risk However, the youth of Chapman's work force suggests a 70% weighting in bonds is too

conservative The mix of large-cap stocks and investment-grade and high-yield bonds is attractive, but most of Chapman'semployees are both young and well-paid, suggesting they have a high risk tolerance as well as low liquidity demands Thebest option is the mix of investment-grade bonds, small-cap and large-cap stocks, and venture capital, the portfolio thatprobably offers the highest total return There is nothing wrong with taking some risks in a pension plan, as long as those risksare well considered and suitable given the characteristics of the work force (Study Session 6, LOS 14.f)

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ᅞ A)

ᅞ B)

ᅚ C)

Questions #78-83 of 175

Which of the following statements would NOT be consistent with an investment policy statement (IPS) for a defined benefit plan?

Adequate liquidity must be maintained to meet liabilities

Tax consequences can be ignored

No objectives and constraints are needed

To better understand the nuances of the insurance industry, Insman attends a one-day seminar at a local university with SaulStetson, another portfolio manager The seminar instructor feels that it is best to separate life insurance from property andcasualty (P&C) insurance companies because of their differing investment objectives and constraints Therefore, the morningsession is devoted strictly to the life insurance industry

The instructor begins by reviewing how the life insurance industry has changed over the years and briefly discusses a variety

of new products He points out that changes in the industry have resulted in the classification of investment activities intosegments having different return objectives He stresses that although life insurance products have a tremendous variety offeatures, his research indicates that return objectives are often segmented as follows:

Cash flow volatility

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Stetson says "I believe P&C liabilities are unknown in timing and amount, whereas life insurance company liabilities areunknown in timing but known in amount."

Insman replies "Are you sure? I thought the instructor said that P&C liabilities are unknown in timing but known in amount,whereas life insurance companies are known in amount and timing."

Insman continues, "Well what about the underwriting cycle? It's approximately five to seven years and tends to follow thegeneral business cycle doesn't it?"

Stetson declares otherwise "I agree that the underwriting cycle is five to seven years long but it runs counter to the businesscycle."

Which of the following best characterizes enhanced margin return?

Enhanced returns from equity-oriented investments designed to increase the

surplus segment

A net interest spread above the returns needed to fund liabilities; thus making it

possible to offer competitive premiums

The excess rate of return derived from using enhanced indexing portfolio

management strategies

Explanation

Enhanced margin: The rate associated with efforts to earn competitive returns on assets funding well-defined liabilities Spreadmanagement techniques are used If done successfully, a return in excess of a policy's crediting rate can be earned, giving lifeinsurance companies a competitive edge in setting policy premiums and adding new business

Surplus return: The difference between total assets and total liabilities is surplus The primary objective of surplus

management is to generate growth, which is key to expanding insurance volume

Minimum return: The mandated return applied to assets earmarked to meet death benefits The minimum rate of return is astatutory rate (normally actuarially determined) that will ensure funding so that reserves are sufficient to meet mortalitypredictions (Study Session 6, LOS 14.i)

Insman wants to subdivide the list of factors impacting life insurance risk tolerance and liquidity Which of the following set offactors best encompasses the most important risk considerations?

Cash flow volatility, disintermediation effects, and asset marketability risk

Credit risk, asset-liability mismatches, and portfolio manager style characteristics

Cash flow volatility, reinvestment risk, and credit risk

Explanation

Cash flow volatility, reinvestment risk, credit risk, and asset valuation fluctuations are generally considered to be the mostimportant risk factors to be evaluated when determining the risk objectives of a life insurance company Liquidity is directly

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affected by the possibility of disintermediation, asset-liability mismatches, and asset marketability risk The style characteristics

of a portfolio manager are considered after risk objectives are determined, not during the formulation of the risk objectives.(Study Session 6, LOS 14.i)

When life insurance companies assess liquidity requirements, they do NOT typically address:

risks associated with liability marketability

asset-liability mismatches

the effects of disintermediation

Explanation

Life insurance companies are required to pay an increasing amount of attention to disintermediation and asset-liability

mismatches Both of these factors impact the liquidity of asset portfolio investments (Study Session 6, LOS 14.i)

Which of the following best describes the accuracy of Insman's and Stetson's statements about P&C versus life insuranceliabilities?

Insman is incorrect; Stetson is incorrect

Insman is correct; Stetson is incorrect

Insman is incorrect; Stetson is correct

Explanation

P&C liabilities are unknown in timing and amount Life insurance companies know the amount of the liability (the death

benefit), but not the timing (Study Session 6, LOS 14.i)

Which of the following best describes the accuracy of Insman's and Stetson's statements about the P&C underwriting cycle?Insman is incorrect; Stetson is incorrect

Insman is incorrect; Stetson is correct

Insman is correct; Stetson is incorrect

Explanation

Evidence indicates the P&C underwriting cycle lasts three to five years and tends to follow general business cycles (StudySession 6, LOS 14.i)

The unique characteristics of P&C liability structure will have the greatest effect on which of the following constraints?

The regulatory environment and unique considerations

Time horizon and taxes

Time horizon and liquidity

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Which of the following statements concerning foundations and endowments is CORRECT? Foundations are:

established to permanently fund some activity and have high degrees of risk

tolerance

grant-making institutions and may have variable time horizons; endowments are

established to permanently fund some activity, and typically have minimum payout

requirements

grant-making institutions and may have variable time horizons; endowments are

established to permanently fund some activity, and typically have infinite lives

Explanation

Foundations are grant-making institutions and may have short or long (infinite) lives Endowments are established to

permanently fund some activity (e.g., provide scholarships) and typically have infinite lives Endowments typically do not haveminimum payout requirements Both types of institutions typically have fairly high degrees of risk tolerance if they are long-lived

The risk tolerance of a foundation differs from that of the fixed-income segment of a life insurance company in which of the followingways? The risk tolerance of a foundation:

will typically be much less than that of the fixed-income segment of a life insurance

company

and that of the fixed-income segment of a life insurance company will both be relatively low

will typically be much greater than that of the fixed-income segment of a life insurance

company

Explanation

The fixed-income segment of a life insurance company's portfolio will essentially be dedicated to providing competitive returns in meetingthe liabilities attached to policies sold Hence, the risk tolerance associated with the fixed-income segment of a life insurance companywill typically be less than that of a foundation, which usually has a moderate to high risk tolerance depending on spending rates

From the perspective of the employer, which of the following statements is most accurate? A defined:

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