16. Asset-liability management Flashcards
1
Q
What are the two key principles of investment?
A
- A provider must select investments that are appropriate to the nature, term, currency, and uncertainty of liabilities and the provider’s appetite for risk
- Subject to the above – Investments should maximize overall return (both income and capital gain)
2
Q
What features need to be covered when asked to describe a cashflow?
6
A
- Direction
- Size
- Nature
- Term and timing
- Currency
- Certainty – timing + amount
3
Q
What are the cashflows on a single life immediate annuity from the perspective of the provider?
A
- Single premium → positive initial lump sum
- Annuity payments → regular series of negative cashflows
* Timing → known
* Amount → monetary or real terms
* Term → unknown – lifetime of insured - Investment → initial negative cashflows – investment of premium
* Series of positive cashflows = interest + capital payments - Expenses:
* Initial lump sum negative cashflow → commission + setup expenses
* Regular negative payments → admin of benefit payments - Expected to increase over time in line with wages/price inflation
4
Q
What are the cashflows of a term assurance from the perspective of the provider?
A
- Premiums → regular series of positive cashflows
* Timing is usually known in advance
* Amount is usually fixed
* Total term is unknown
* A variation is a single premium contract - Benefit → a lump sum negative cashflow
* Paid on death of the policyholder
* Timing is unknown
* Amount of sum assured is known
* If survives term → no benefit cashflow - Investment
* A series of positive cashflows of interest and capital
* Negative cashflow when investments are purchased - Expenses
* Initial lump sum negative cashflow to cover commission and setup expense
* Regular negative cashflows → admin expense
* Termination lump sum → negative cashflow payable on death → claims handling
5
Q
How do the cashflows from the perspective of the provider on a without-profit endowment assurance differ from those on a TA?
A
- Additional negative lump sum cashflow on maturity
1. If the policyholder survives until the end of the term
2. Amount will be known - May be a lump sum negative cashflow if the policyholder surrenders
1. Amount may or may not be known – depends on contract - For a given sum assured → the premiums will be greater
- Investment income and gains would also be greater
6
Q
What are the cashflows of a repayment loan from the perspective of the provider?
A
- Loan amount → initial negative cashflow equal to the amount of the loan
- Interest and capital repayments → regular series of positive cashflows
* Each payment = interest + capital
* Capital component increases over the term
* Interest component decreases over the term of the loan
* Total amount may be fixed or variable
* Or specified to increase or decrease
* Timing and total term is usually known in advance unless it is paid early or a party defaults - Expenses
* Initial lump sum negative cashflow to cover commissions and setup expense
* Regular stream of negative cashflows → admin + collecting payments expected to increase in line with price or wage inflation
7
Q
How are the cashflows on an interest-only loan different from those of a repayment loan?
A
- Interest-only → regular repayments only comprise interest
- Interest may be fixed or variable
- Additional lump sum positive inflow → capital repayment
* Amount is known and equal to the initial loan amount
* Timing is known = end of term
* Unless borrower dies, repays early, or defaults
8
Q
What are the cashflows on a motor insurance contract from the perspective of the provider?
A
- Premiums
* Lump sum positive cashflow paid at the start of the year
* Or a positive series of monthly cashflows paid throughout the year
* Amount and timing are known unless endorsements are made or the policyholder defaults - Claims
* Negative cashflows to cover admin
* More than one claim payment may be made for the period of cover
* Reporting or settling delays possible
* Timing and amount are unknown - Investment
* Series of positive cashflows from income and gains from investments
* Negative cashflow when investments are purchased - Expenses
* Initial negative cashflow → setup expenses + admin
* Negative cashflows between claim reporting and settlement to cover claim expenses
9
Q
What is net liability outgo for a provider?
A
- Benefits (claims) + expenses – premium income/contribution
10
Q
What are the four types that liabilities can be divided into according to their nature?
A
- Guaranteed in money terms
- Guaranteed in terms of an index
- Discretionary (e.g. bonuses on with-profit contracts)
- Investment-linked (e.g. unit-linked liabilities)
11
Q
Where might expenses and premiums be categorized?
A
- Expenses → tend to increase over time at a rate between price and earnings inflation → Guaranteed in terms of an index
- Premiums/contributions → negative liabilities
* Fixed in monetary terms → negative benefit payments guaranteed in monetary terms
* Expected to increase in line with inflation → negative benefits guaranteed in terms of an index
12
Q
What is a good asset match for liabilities guaranteed in money terms?
5
A
- Conventional bonds of appropriate terms
- Exact match is unlikely → exact timing of A proceeds unlikely to match exactly with L outgo
- Available bonds may not be long enough in duration
- Bonds should be of high quality since the benefit is guaranteed
- Derivatives could be used → expensive + exact matching not always possible
13
Q
What is a good asset match for liabilities guaranteed in terms of an index?
2
A
- Index-linked bonds at an appropriate term
* May not be available and index may not be the same as liabilities - Equities and properties may provide a broad match
14
Q
What is a good match for discretionary liabilities?
A
- Assets expected to produce a high real yield → equity or property
- Consider policyholders’ expectations + provider’s risk appetite
15
Q
What is a good match for investment-linked liabilities?
3
A
- Provider can avoid any investment matching problems by investing in the same assets used to determine benefits
- If this requires tracking a market index (holding large numbers of small holdings) → it can be costly
- Use collective investment schemes to track the investment or a derivative strategy
16
Q
How Does the Existence of Free Assets (Surplus) Affect the Investment Strategy of an Insurance Company?
7
A
- Free assets provide a cushion against adverse investment experience.
- With free assets, the insurer can depart from a matched position and potentially achieve a higher overall return.
- Alternatively, insurers must use free assets to reduce risk and move to a more matched position.
- Sufficient assets are needed → Investing in high-risk assets and moving away from a matched position increases the risk of not meeting future obligations and insolvency.
- Competing uses of free assets:
1. Writing new business
2. Providing discretionary benefits - Opportunities to depart from a matched position for guaranteed liabilities are limited.
- In some territories, mismatching of investment-linked liabilities may be restricted by law or regulation.
17
Q
How Can a Mismatching or Resilience Reserve Be Determined?
A
- Deterministic Approach
* Select assets (A) to exactly match liabilities (L).
* Recalculate A and L values under stressed economic factors (e.g., interest rate changes).
* If the stressed value of A < stressed value of L, the difference is the mismatching reserve that should be held. - Stochastic Approach
* Perform stochastic simulation of market conditions using an economic scenario generator.
* Inspect the tails of the stochastic output.
* Determine the mismatch reserve as the amount of free assets needed to prevent insolvency at the desired probability level.
18
Q
How Might the Regulatory Framework Limit a Provider’s Investment Options?
A
TECH SCAM
- Types of assets a provider can invest in
- Extent to which mismatching is allowed
- Currency matching requirement
- Hold certain assets
- Single counterparty risk management→ restriction on maximum exposure
- Custodianship of assets (custodian holds investments and accounts for financial transactions)
- Amount of any one asset held to demonstrate solvency may be restricted
- Mismatching reserve requirements
19
Q
What is Pure Matching?
A
- Structuring the flow of income and maturity proceeds from assets so they coincide precisely (nature, timing, and currency) with net liability outgo under all circumstances.
20
Q
Why is Pure Matching Not Always Possible?
4
A
- Timing or amounts of asset proceeds or liability outgo may be uncertain.
- Pure matching may require excessive investment in certain securities → prohibitive.
- Pure matching may require zero-coupon bonds (ZCBs) with exact liability terms, which may not exist or be too expensive.
- Some liabilities are very long-term, and suitable dated assets may not exist.
21
Q
What is Liability Hedging?
A
- Assets are chosen to perform in a similar way to liabilities.
- Aims to select assets that behave exactly like liabilities in all scenarios.
- Usually not fully possible → Instead, liabilities are hedged against specific factors (e.g., currency matching, hedging unit-linked liabilities).
22
Q
What is Unit-Linked Liabilities Hedging?
A
- Establish a portfolio of assets and calculate the price of each unit from the asset values.
- Use this price to value units of liabilities, ensuring assets and liabilities remain aligned.
23
Q
What is Immunisation, basic explanation and conditions (3)?
A
- Investing assets so that the present value (PV) of assets and liabilities remains immune to small interest rate changes.
- Basic Explanation of Immunisation
1. Used when pure matching is not possible → reduces risk of liabilities exceeding assets due to changing investment conditions.
2. Assumes that securities exist with a uniform yield across all terms. - Conditions for immunisation
1. V(A) = V(L); PV(A) = PV(L)
2. Discounted mean term (DMT) of asset proceeds = DMT of liability outgo: tV^tA_t/V^tA_t
3. Spread/convexity of assets > Spread of liabilities
t^2V^tA_t/V^tA_t
24
Q
What are the Limitations of Classical Immunisation Theory?
A
TAMARAI
- Timing of asset proceeds and liability outgoes may be uncertain.
- Aimed at meeting monetary liabilities, but investors may need to match real liabilities.
- Mismatch profits and losses are removed except for small second-order effects → limits investment in equities and property.
- Assumes a flat yield curve and the same interest rate change across all terms.
- Relies on small interest rate changes → may not protect against large changes.
- Assets with suitable long DMT may not exist.
*
25
What is an Asset-Liability Model (A-L Model)?
* Deterministic or stochastic model that helps institutional investors set an investment strategy.
* Defined by:
1. Specified objective
2. Measurable target
3. Time horizon
4. Confidence level
* A-L model projects future cashflows of both assets and liabilities and values them.
* The model is run iteratively to determine an optimal investment strategy.
* Should be dynamic → allows for correlation between A and L cashflows.
26
How Can the Success of an Investment Strategy Be Monitored Using an A-L Model?
* Regular valuations.
* Compare valuation results with projections from the modelling process.
* Adjustments made to control the level of risk accepted by the strategy.
* Essentially, compare experience with expectations
