IFoA SA7 key terms

An addition to the risk-free yield used to discount eligible long-dated liabilities when the insurer holds matching assets to maturity; it reflects the illiquidity premium of those assets and is subject to regulatory eligibility tests.

The extra yield investors demand for holding an asset that cannot be sold quickly without a price concession. In insurance valuation it is the portion of spread attributed to illiquidity rather than credit risk.

The amount of capital a regulated insurer must hold so that it can absorb a specified severe shock over one year with a prescribed probability of remaining solvent, often calibrated to a 99.5% one-year value-at-risk.

An additional liability held above best-estimate reserves to compensate a hypothetical transferee for bearing insurance risk until obligations run off; calculated as the cost of holding required capital over the liability's lifetime.

The probability-weighted present value of future policyholder cash flows, including expenses and options and guarantees, calculated without any prudential margin and using current assumptions.

A firm's own risk and capital quantification framework approved by the regulator for setting regulatory capital, allowing firm-specific dependencies and diversification to be captured where the standard formula is too crude.

A measure of a bond's price sensitivity to small changes in yield, expressed in years; the percentage price change is approximately the modified duration multiplied by the yield change.

The second-order sensitivity of a bond's price to yield changes. Positive convexity means price gains exceed losses for equal yield moves, so the duration approximation understates value when yields fall.

A fixed-income strategy that matches the duration of assets to liabilities so that the portfolio's value is protected against small parallel shifts in interest rates over a defined horizon.

A plot of yields against maturity for bonds of similar credit quality at a point in time, whose level, slope and curvature drive pricing, hedging and liability discounting decisions.

The excess yield of a corporate or other non-government bond over a comparable-maturity government bond, compensating investors for default risk, downgrade risk and illiquidity.

The probability that a bond issuer fails to pay interest or principal when due, and the loss severity if it does, together driving expected credit loss on a portfolio.

The movement of an issuer or issue between rating grades over time, which changes required spreads and can force sales by mandate-restricted holders even without any default.

Projecting asset and liability cash flows and values together under many economic and demographic scenarios to test solvency, funding and strategy choices for an insurer or pension scheme.

A stochastic model producing consistent paths of interest rates, inflation, equity returns, spreads and other factors, calibrated to market prices and used as input to asset-liability and capital modelling.

Placing a value on liabilities or assets using the prices of traded instruments that replicate their cash flows, so the value is independent of the holder's own views on expected returns.

Pricing derivatives by discounting expected payoffs computed under a probability measure in which all assets earn the risk-free rate, so no risk premium appears in the drift.

A closed-form option pricing framework assuming lognormal asset prices, constant volatility and continuous hedging, giving values driven by spot, strike, time, volatility, rates and dividends.

The volatility input that, when inserted into an option pricing model, reproduces the observed market price; its variation across strikes and maturities reveals the market's skew and smile.

The pattern whereby implied volatility differs across option strikes, typically higher for deep out-of-the-money options, reflecting fat tails and crash risk absent from simple lognormal models.

An agreement to exchange fixed and floating interest payments on a notional principal over a set term, used to change the interest rate profile of assets or liabilities without selling the underlying.

The degree to which a derivative or other instrument offsets changes in the fair value or cash flows of the risk being hedged, assessed statistically and required for hedge accounting treatment.

The risk that the price of a hedging instrument and the hedged exposure do not move in perfect lockstep, leaving residual variability in the hedged outcome.

A loss threshold that is expected to be exceeded only with a stated small probability over a defined horizon; it says nothing about the size of losses beyond that threshold.

The average loss conditional on losses exceeding a given confidence level, capturing tail severity that value at risk ignores and preferred where loss distributions are fat-tailed.

The risk of extreme outcomes in the far tail of a return distribution, occurring more often than normal models predict and often coinciding across supposedly diversified assets.

Allocating a portfolio's total risk, rather than just its capital, across asset classes, managers or strategies, so each contributes a planned share of volatility or tracking error.

The standard deviation of the difference between portfolio and benchmark returns, measuring how closely a manager follows a benchmark and how much active risk is being taken.

Active return divided by tracking error, expressing how much excess return a manager earns per unit of active risk taken; used to judge skill and to size active mandates.

Decomposing a portfolio's return relative to a benchmark into sources such as asset allocation, security selection, currency and interaction effects, to explain and evaluate results.

The long-term mix of asset classes chosen to meet an investor's return objective and risk tolerance given liabilities and constraints, typically reviewed only periodically.

Short-term deliberate deviations from the strategic mix, taking positions in asset classes or markets based on expected relative returns within agreed risk limits.

Investments such as private equity, private credit and infrastructure that cannot be sold quickly at a reliable price, typically offering a premium in exchange for locking up capital.

Estimating the market worth of real estate using income, comparable-sales or cost approaches, producing a smoothed appraisal that may lag true transaction prices.

The tendency of appraised or model-based asset values to understate true volatility by carrying stale information forward, which flatters measured risk and correlations in reported returns.

The average return of a portfolio in excess of that predicted by the capital asset pricing model given its beta, used as a measure of risk-adjusted outperformance.

A systematic, predictable departure from rational decision-making, such as anchoring, loss aversion or overconfidence, that can distort investment choices and should be mitigated by governance.

The tendency of investors to follow the crowd rather than independent analysis, amplifying price momentum and bubbles and increasing correlated risk across portfolios.

The structures, delegated authorities, committees and controls through which investment decisions are made, monitored and held accountable, including conflicts of interest and stewardship arrangements.