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IAI Actuarial Core Principles · Business Economics · Impact of the macroeconomic environment on business

An Indian life insurer holds a large portfolio of long-dated fixed-rate government bonds. Market interest rates rise sharply. Which is the most likely direct consequence for the insurer?

When market rates rise, the market price of existing fixed-rate bonds falls because their fixed coupons are less attractive relative to new yields. The insurer's asset values therefore decline, and the net solvency effect depends on how well durations are matched.

  1. AThe market value of the bond holdings falls, reducing the value of assets relative to liabilities, other things equalCorrect
  2. BThe market value of the bond holdings rises because coupons look more attractive
  3. CThe present value of its long-term liabilities rises more than its assets
  4. DReinvestment income on existing bonds rises immediately at the old coupon
  5. The insurer's solvency is unaffected because bonds are risk-free

Explanation

Bond prices move inversely with yields, so fixed-rate holdings lose market value. Higher rates also lower the present value of liabilities, so the net effect depends on duration matching, but the direct asset effect is a fall. Existing coupons stay fixed.

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