C15 Asset Liability Management

Question 1

Principles of Investment for a provider of benefits on uncertain future events

Answer 1

1. Provider should select investments that are appropriate to the nature, term and currency of the liabilities and the provider’s appetite for risk
2. Investments should also be selected to maximise the overall return on the assets, where overall return includes both income and capital

Question 2

State 3 components of net ‘liability outgo’

Answer 2

Net liability outgo consists of:
Benefit payments
+ Expense outgo
- Premium/contribution income

Question 3

Different category of nature of benefits provider’s outgo

Answer 3

1. Guaranteed in money terms
2. Guaranteed in terms of an index
3. Discretionary
4. Investment-linked

Question 4

Nature of expenses

Answer 4

• Expenses tend to increase over time at a rate between price and earnings inflation
• Hence, they can be guaranteed in terms of an index of prices or similar

Question 5

Nature of premium/contribution income

Answer 5

Premiums/contributions represent negative liabilities.
They may be:
- Fixed in monetary terms and (negative benefit payments guaranteed in money terms)
- Expected to increase in line with an index (negative benefit payments guaranteed in terms of an index)

Question 6

Matching liabilities that are guaranteed in money terms

Answer 6

High quality fixed interest bonds
- Exact match is normally impossible since timing of asset proceeds is unlikely to coincide exactly with liability outgo.
- Bonds may not be long enough in duration.
- Derivatives, Immunisation or Liability Hedging can be used to achieve best match

Question 7

Matching liabilities that are guaranteed in terms of an index

Answer 7

1. Index linked bonds – may not exist or may not be linked to exactly the same index as the liabilities.
2. Equities
3. Property

Question 8

Matching liabilities that are discretionary

Answer 8

1. Main aim of the provider will be to maximise benefits/returns.
2. Invest in assets with high expected return subject to
3. PRE,
4. Appetite for risk
5. Level of free assets

Question 9

Matching liabilities that are investment-linked

Answer 9

• Invest in same assets used to determine benefits.
• However, replicating a market index may involve holding a large number of small holdings and be thus being too costly.
  1.Companies may choose to use collective investment 2. schemes or a derivative strategy to achieve this

Question 10

Matching liabilities that are denominated in a particular currency

Answer 10

Liabilities denominated in a particular currency should be matched by assets in that currency, to reduce currency risk

Question 11

Benefits of free assets/surplus

Answer 11

Provider can depart from matching strategy so as to improve overall return on its assets
Benefits
1. Higher benefits
2. Lower conts/premium
3. Higher dividends to shareholders

Question 12

Impact of free assets on investment strategy of an insurance company

Answer 12

Impact of free assets on investment strategy of an insurance company:
- Free assets act as a cushion against adverse investment experience
- May be possible to depart from matched strategies in pursuit of higher expected returns (and hence higher benefits or profits or lower premiums)
- Needs to be sufficient free assets since mismatching and investing in higher risk / higher return assets increases risks of not meeting guaranteed liabilities and of insolvency
- For discretionary liabilities, free assets help to ensure that PRE are met
- May be competing uses of free assets, e.g. writing NB, which limit the potential to mismatch
- In some territories, mismatching of investment-linked liabilities may not be permitted

Question 13

Investment controls by regulator

Answer 13

TECH SCAM
1. Types of asset can invest in
2. Extent of mismatching allowed
3. Currency match assets and liabilities
4. Hold certain assets e.g. Gilts

5. Single counterparty maximum exposure
6. Custodian of assets
7. Amount of any one asset used to demonstrate solvency
8. Mismatch reserve

Question 14

Describe Matching a series of fixed outgoings (pure matching)

Discuss whether it is likely to be possible in practice

Answer 14

Pure matching involves structuring flow of income and maturity proceeds from assets so they will coincide precisely with the net outgo from liabilities in under all circumstances

Why it is not possible:
1. Timing or amount of asset proceeds or liability outgo may be uncertain.
2. Involves buying excessive amounts of certain securities which would be expensive.
3. Generally requires risk free zero coupon bonds or strips with exactly same term as liabilities which do not usually exist or are too expensive.
4. Some liabilities are so long term that suitably long dated assets do not exist.

Question 15

Explain the thinking behind asset-liability modelling (ALM) to determine an investment strategy

Answer 15

• An ALM is a deterministic or stochastic model that can be used to help an institutional investor set an investment strategy.
• Model will have a specified objective with a measurable target that refers to assets and liabilities, a time horizon and a probability confidence interval (if a stochastic model). ex. value of assets less value of liabilities must be greater than zero 95% of the time
• For a particular investment strategy, an ALM projects asset proceeds and liability outgo cashflows into the future and values them.
• Model is run and re-run, each time changing the investment strategy, until the stated objective is met.
• Model should be dynamic, i.e. allows for correlations between asset and liability cashflows

Question 16

Deterministic v stochastic modeling

Answer 16

Deterministic Model
- Based on a set of specific assumptions about future
- Can be varied individually (sensitivity testing) or collectively (scenario testing) to model a series of different possibilities

Stochastic model
- Some assumptions are treated as random variables
- Model is usually run thousands of times using different values of the random variables
- Output is a distribution of possible outcomes
- Sensitivity and scenario testing will also be carried out on assumptions that are modelled deterministically

Question 17

How is the success of the strategy developed using ALM monitored

Answer 17

Monitoring the success of the output of an ALM:

• Success of strategy is monitored by means of regular valuations.
• Valuation results will be compared with the projections from modelling process and adjustments made to the strategy to control the level of risk accepted by the strategy, if necessary

Question 18

Define the term ‘Liability hedging’ and give examples

Answer 18

Liability hedging is where assets are chosen in such a way as to perform in the same way as the liabilities.

Aims to select assets that perform exactly like liabilities in all states.
Not achievable in practice, Instead, investor might try to hedge liabilities wrt specific factors
Examples:
1. Immunisation
2. Currency matching
3. Hedging unit-linked liabilities

Question 19

Unit -linked liability hedging and problems with it

Answer 19

Unit-linked liability hedging:
- Price of each unit is determined in relation to value of assets.
- Value of the liabilities, i.e. the units, is then linked to assets

Problems:
- Frequent switching of money between funds can cause volatility particularly for small holdings
- If assets are managed by a third party, may be lack of knowledge to what is held
- Assets held may not be exactly the same as those underlying the value of liabilities