16 Asset-Liability Management

Question 1

What is the basic investment principle of a life insurance company? (4)

Answer 1

To maximise investment return,

• subject to meeting all contractual and TCF obligations
• recognising the uncertainties involved
• and the overall risk that the shareholders, regulators and policyholders are prepared to tolerate.

Question 2

Comment on the difficulty of cashflow matching for: (6)

1. Non-profit business
2. With-profit business
3. Variable annuity business

Answer 2

Non-profit business:

• Matching cashflows is fairly straightforward
• Unless suitable assets don’t exist or their availability is limited.

With-profit business:

• Matching is made harder by discretionary benefits and TCF constraints.
• The split between regular and terminal bonus affects the build up of guarantees and so matching requirements.

Variable annuity business:

• Matching is complex.
• Guarantees are typically dynamically hedged using combinations of derivatives.

Question 3

Describe an Economic Scenario Generator. (5)

Answer 3

An ESG is a stochastic model that generates simulations of possible future economic scenarios.

Typical ESG outputs include:

• Macroeconomic variables, e.g. inflation, interest rates
• Asset returns, e.g. for equities, property, bonds

ESG input parameters can be calibrated depending on the purpose:

• A risk neutral (market consistent) calibration is typically used for valuation purposes. The idea is to replicate actual market prices as closely as possible.
• A real-world calibration is typically used for projecting into the future. The focus here is to use assumptions in line with long-term realistic expectations.

Question 4

List four reasons life assurance companies may use derivatives as part of their ALM strategies. (4)

Answer 4

1. Increase available capital by reducing regulatory capital requirements.
2. Reduce tax or investment costs.
3. Efficiently increase or decrease exposure to assets.
4. Hedge guarantees e.g. in relation to variable annuities, guaranteed equity bonds and with-profit contracts.

Question 5

List four residual risks that may be introduced by the use of derivatives. (4)

Answer 5

1. Counterparty risk
2. Liquidity risk
3. Operational risk
4. Basis risk