This reading and this particular topic seems to give students a lot of trouble. Sometimes in our studies, we view actuarial functions in a vacuum and don’t necessarily see the other moving parts that make it all work in the real world. The treasury function is an example of this and is why understanding the ‘what’ and ‘how’ of the Treasury function feels a bit awkward and non-intuitive.
For the exam…
The primary purpose of the treasury function is to distinguish between earnings generated by underwriting activities and earnings generated by investment activities. This makes sense but to see how it works, let’s break the example given in the study note into manageable pieces using normal vocabulary that we understand, introduce the terminology from the reading, and finally tie it all together.
Underwriting Function
The underwriting function specializes in insurance risk so that if an insurance product is underwritten correctly and experience turns out to be as expected, the underwriting function has done a good job. If experience is better than expected, the underwriting function as done a really good job and there are additional earnings to the company than what was originally priced and expected. Lastly, if experience is worse than anticipated, there will be additional losses than expected.
Another way to look at this is to assume that underwriting function has its own balance sheet. On the liability side, the actual insurance liabilities are owed to the customers. On the asset side, we have an ‘asset’ that exactly matches the expected value of the liabilities (remember – we already said that if experience is expected, then there is no additional gain/loss). Let’s call this value the “Replicating Portfolio.” As experience materializes, the liability payout to the customer will either be equal/more/less than this value and generate a scratch/gain/loss based solely on underwriting as we described in the previous paragraph.
Investment Function
The investment function is responsible for the company’s assets. They are given a required yield and then go to the market and invest in assets to reach this yield or better (very simplified). Let’s say that they are given a 1 year asset value target of $X needed to back customer liabilities. If in 1 year, the asset portfolio exactly equals $X, they've done their job and there’s no additional earnings. Following the same logic as the Underwriting function, the actual asset portfolio can be greater than or less than $X in 1 year which then generates additional gains or losses. Remember, the Investment function of an insurance company is trying to make investment gains based on strategic investments.
Again – another way to look at this is to assume that the investment function has its own balance sheet. On the asset side, it owns the actual assets that were purchased in the market. On the liability side, it OWES the company some target level of assets ($X in the above example). If actual asset performance is better, additional gains are generated; if actual asset performance is worse then there is a loss (to the investment function) as it doesn’t have enough to pay back the target level of assets $X. Let’s call this target level of assets $X the “Strategic Asset Allocation (SAA) benchmark portfolio”
Treasury Function
Let’s begin our look at the treasury function by first pointing out a very important observation. If the Replicating Portfolio = SAA benchmark portfolio, then the treasury function acts as a strict middleman. They would receive the Replicating Portfolio value from Underwriting and simply pass it on to Investment as the SAA benchmark portfolio. Asset performance vs the SAA benchmark portfolio will determine investment gains/losses; Liability experience vs. Replicating portfolio will determine underwriting gains/losses.
From this simplified situation, we can start to build the balance sheet for the treasury function. Its assets are represented by the SAA that the investment function owes them; the liabilities are the replicating portfolio that it then owes to underwriting. In practice, the treasury function determines the level of risk that a company should take for strategic reasons as reflected by the SAA benchmark. Thus – the SAA benchmark (asset) > Replicating portfolio (liability) and guess what the balancing item is: shareholder equity.
So in the end, we see the company level economic balance sheet: Assets = Liabilities + Shareholder equity where each component is held on the balance sheet of a specific function:
Obviously this is just a crash course in the role of the treasury function and any seminar or study manual will likely go into more detail. But with the exam around the corner – you should aim to learn ‘enough’ about the topics that have given you trouble so that you are in a position to write something on the exam rather than leaving a question blank. Hope this helps!!
For the exam…
The primary purpose of the treasury function is to distinguish between earnings generated by underwriting activities and earnings generated by investment activities. This makes sense but to see how it works, let’s break the example given in the study note into manageable pieces using normal vocabulary that we understand, introduce the terminology from the reading, and finally tie it all together.
Underwriting Function
The underwriting function specializes in insurance risk so that if an insurance product is underwritten correctly and experience turns out to be as expected, the underwriting function has done a good job. If experience is better than expected, the underwriting function as done a really good job and there are additional earnings to the company than what was originally priced and expected. Lastly, if experience is worse than anticipated, there will be additional losses than expected.
Another way to look at this is to assume that underwriting function has its own balance sheet. On the liability side, the actual insurance liabilities are owed to the customers. On the asset side, we have an ‘asset’ that exactly matches the expected value of the liabilities (remember – we already said that if experience is expected, then there is no additional gain/loss). Let’s call this value the “Replicating Portfolio.” As experience materializes, the liability payout to the customer will either be equal/more/less than this value and generate a scratch/gain/loss based solely on underwriting as we described in the previous paragraph.
Investment Function
The investment function is responsible for the company’s assets. They are given a required yield and then go to the market and invest in assets to reach this yield or better (very simplified). Let’s say that they are given a 1 year asset value target of $X needed to back customer liabilities. If in 1 year, the asset portfolio exactly equals $X, they've done their job and there’s no additional earnings. Following the same logic as the Underwriting function, the actual asset portfolio can be greater than or less than $X in 1 year which then generates additional gains or losses. Remember, the Investment function of an insurance company is trying to make investment gains based on strategic investments.
Again – another way to look at this is to assume that the investment function has its own balance sheet. On the asset side, it owns the actual assets that were purchased in the market. On the liability side, it OWES the company some target level of assets ($X in the above example). If actual asset performance is better, additional gains are generated; if actual asset performance is worse then there is a loss (to the investment function) as it doesn’t have enough to pay back the target level of assets $X. Let’s call this target level of assets $X the “Strategic Asset Allocation (SAA) benchmark portfolio”
Treasury Function
Let’s begin our look at the treasury function by first pointing out a very important observation. If the Replicating Portfolio = SAA benchmark portfolio, then the treasury function acts as a strict middleman. They would receive the Replicating Portfolio value from Underwriting and simply pass it on to Investment as the SAA benchmark portfolio. Asset performance vs the SAA benchmark portfolio will determine investment gains/losses; Liability experience vs. Replicating portfolio will determine underwriting gains/losses.
From this simplified situation, we can start to build the balance sheet for the treasury function. Its assets are represented by the SAA that the investment function owes them; the liabilities are the replicating portfolio that it then owes to underwriting. In practice, the treasury function determines the level of risk that a company should take for strategic reasons as reflected by the SAA benchmark. Thus – the SAA benchmark (asset) > Replicating portfolio (liability) and guess what the balancing item is: shareholder equity.
So in the end, we see the company level economic balance sheet: Assets = Liabilities + Shareholder equity where each component is held on the balance sheet of a specific function:
- Assets: Investment function
- Liabilities: Underwriting function
- Shareholder Equity: Treasury function
Obviously this is just a crash course in the role of the treasury function and any seminar or study manual will likely go into more detail. But with the exam around the corner – you should aim to learn ‘enough’ about the topics that have given you trouble so that you are in a position to write something on the exam rather than leaving a question blank. Hope this helps!!
Treasury function (LP-113-09)
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