CH 16: Asset-liability management

Question 1

Interaction between assets and liabilities

3

Answer 1

• Aim to achieve matching so risk is minimised, also provides lower returns than unmatched.
• Optimal matched position: degree of certainty in meeting liabilities, regulatory requirements, investment objectives
• Unmatched strategy: Additional capital needs to be held to cover risk that assets are insufficient

Question 2

What are the two key principles of investment?

2

Answer 2

1. Select investments that are appropriate to the:
   Nature, term, currency and uncertainty of the liabilities
   Provider’s appetite for risk.
2. Subject to the first constrain, the investments should be selected to maximize the overall return on the assets, where overall return includes both income and capital gains.

Question 3

List the features that describe a cashflow

6

Answer 3

1. Direction (positive or negative)
2. Size
3. Nature (Real/Nom)
4. Term and timing (regular/lump sum)
5. Currency
6. Certainty (of both timing and amount)

Question 4

Describe the cashflows on a single life immediate annuity from the perspective of the provider

Answer 4

Single premium - an initial lump sum positive cashflow

Annuity payments - a regular series of negative amounts. The timing of these cashflows are usually known. The amount will usually be known either in monetary or real terms. The total term of payment is unknown as it will depend on how long the annuitant lives.

Investment - an initial negative cashflow, then a series of positive cashflows in the form of interest and capital payments from the bonds in which the provider has invested.

Expenses - an initial lump sum negative cashflow to cover commission and set up expenses. This is followed by a regular stream of negative cashflows to cover the administration of paying benefits. These can be expected to increase over time in line with a mixture of price / wage inflation.

Question 5

Describe the cashflows on a term assurance from the perspective of the provider

Answer 5

Premiums - a regular series of positive payments. The timing is usually known. The amount is usually known and fixed. The total term of premium payment is unknown as it will depend on when/if the policyholder dies. A variation is a single premium contract.

Benefit - a lump sum negative cashflow paid on the death of the policyholder. The timing is unknown. The amount of the sum assured is known. If the policyholder survives then there will be no benefit cashflow.

Investment - a series of positive cashflows in the form of income and gains from the investments in which the provider has invested ( and negative cashflows when the investments are initially purchased)

Expenses - an initial lump sum negative cashflow to cover commission and set-up expenses. A termination lump sum negative cashflow is payable on death to cover claims handling expenses. There will also be regular negative cashflows to cover administration expenses.

Question 6

Describe how the cashflows from the perspective of the provider on a (without-profit) endowment assurance differ from those on a term assurance

Answer 6

There will be an additional lump sum negative cashflow on the maturity date of the contract if the policyholder survives until the end. The amount will be known.

There may be a lump sum negative cashflow if the policyholder surrenders the contract before the end of the contract term. The amount may be known or unknown, depending on the terms of the contract.

For a given sum assured, the premiums will be greater than for a term assurance policy.

Investment income and gains will also be greater.

Question 7

Describe the cashflows on a repayment loan from the perspective of the provider

Answer 7

Loan amount - an initial lump sum negative cashflow equal to the loan amount

Interest and capital payments - a regular series of positive payments. Each payment comprises part interest, part capital. The capital (interest) component increases (decreases) over the period of the loan. The total amount may be fixed, variable, or specified to increase / decrease over the period of the loan. The timing and the total term of payments is usually known, unless the loan is repaid early or the borrower defaults.

Expenses - an initial lump sum negative cashflow to cover commission and set - up expenses. This is followed by a regular stream of negative cashflows to cover the administration of collecting premiums. These can be expected to increase over time in line with a mixture of price / wage inflation.

Question 8

Describe how the cashflows on an interest only loan differ from those on a repayment loan from the perspective of the provider

Answer 8

For an interest only loan the regular payments received by the provider comprise only interest, not interest and capital. The amount may be fixed or variable.

There will be an additional lump sum positive cashflow: the capital repayment. The amount is usally known and equal to the initial loan amount. The timing is usually known unless the borrower dies, repays the loan early or defaults.

Question 9

Describe the cashflows on a motor insurance contract from the perspective of the provider

Answer 9

Premiums - a lump sum positive cashflow paid at the start of the year or a regular series of positive monthly cashflows paid throughout the year. The amount and timing if the cashflows are usually known unless endorsements are made to the policy throughout the year or the policyholder dies.

Claims - negative cashflows to cover the costs of claims. There may be more than one claim payment in respect of the period of cover and there may be reporting and settlement delays. The timing and amount of the cashflows are unknown.

Investment - a series of positive cashflows in the form of income and gains from the investments in which the provider has invested ( and negative cashflows when the investments are initially purchased)

Expenses - an initial lump sum negative cashflow to cover commission and set up expenses. Negative cashflows incurred between claim reporting and settlement to cover claim expenses.

Question 10

Define the ‘net liability outgo’ for a provider

2

Answer 10

• Benefits (or claims) + expenses - contributions (or premium) income
• Main CF’s that need to be described are Benefits,Expenses,Premium income

Question 11

Four types of Benefit liabilities by nature

4

Answer 11

1. Guaranteed Nominal: Amt is specified in monetary terms
2. Guaranteed Index linked: Amt is linked to and index
3. Discretionary: Payable under discretion of provider
4. Investment linked: Amt directly determined by value of underlying investments

Question 12

Expense Liability

2

Answer 12

• Increase over time in line with inflation
• Usually linked to prices/ earnings

Question 13

Premium income

1

Answer 13

• Can be fixed or index linked

Question 14

Suggest a good asset match for liabilities guaranteed in money terms

4

Answer 14

• Conventional bonds of an appropriate term.
• However, an exact match is normally impossible since the timing of the asset proceeds is unlikely to coincide exactly with the liability outgo. Additionally, the available bonds may not be long enough in duration.
• The bonds should be of high quality given that the benefit is guaranteed.
• Derivatives could be used, but are generally considered expensive and exact matching may not always be possible.

Question 15

Suggest a good asset match for liabilities guaranteed in terms of an index

3

Answer 15

• Index linked bonds of an appropriate term.
• However, these may not be available or they may not be linked to exactly the same index as the liabilities.
• Alternatively, equities or property may provide a broad match in the long term if diversfied

Question 16

Suggest a good match for discretionary liabilities

2

Answer 16

• Assets expected to yield a high, real return, e.g. equities or property as aim is to maximize discretionary benefits
• However, the choice will also be affected by policyholders’ expectations and the provider’s appetite for risk.

Question 17

Suggest a good asset match for investment linked liabilities

3

Answer 17

• Benefits are ‘guarenteed’ as they can be determined at any time from value of investment.
• The provider can avoid any investment mismatching problems by investing in the same assets as used to determine the benefits.
• If this requires replicating a market index then it may involve holding a large number of small holdings and thus be too costly. Companies might choose to use CISs that track the investment or a derivative strategy to do this.

Question 18

Explain how the existence of free assets affects the investment strategy of an insurance company

5

Answer 18

1. Free assets act as a cushion against adverse investment experience.
2. With free assets, it may be possible to depart from the matched strategies suggested previously in pursuit of higher expected returns (and hence higher benefits, lower premiums or higher profits)
3. However, there need to be sufficient free assets since mismatching and investing in higher risk / higher return assets increases the risks of not meeting guaranteed liabilities and of insolvency.
4. There may be competing uses of free assets which limit the potential to mismatch
5. In some territories, the mismatching of investment-linked liabilities may not be permitted by law or by regulation.

Question 19

Mismatching on types of benefits

4

Answer 19

Guarenteed benefits:
* Mismath to max returns, hold free assets to cover shortfall. (mismatch reserve)

Discretionary benefits:
* Aim to achieve max benefits so no point in matching.
* PH expectations to receive min benefit use free assets to ensure min benefit met

Investment linked:
* Mismatch achieve greater returns and generate profits.
* High risk and prevented by regulation

Banking sector:
* Active mismatch, Borrow short lend long
* Create liquidity risk

Question 20

Outline two methods by which a mismatching reserve might be determined

3,2

Answer 20

1.Deterministic approach
- Select assets held that are equal to the value of the liabilities
- Recalculate the values of these assets and liabilities under stresses to economic factors such as interest rates
- If the stressed asset value is less than the stressed liability value, the difference is the mismatching reserve that should be held.

2.Stochastic approach
- Perform a stochastic simulation of the markets in which funds are invested using and economic scenario generator.
- By inspecting the tails of the stochastic output, determine the mismatching reserve as the amount of the free assets that is needed in order to just prevent insolvency at the desired probability level.

Question 21

Give 8 examples of how the regulatory framework might limit providers investment choice

Answer 21

• Types of assets the provider can invest in
• Extent to which mismatching is allowed
• Currency matching requirement
• Hold certain assets
• Single counterparty maximum exposure
• Custodianship of assets
• Amount of any one assets used to demonstrate solvency may be restricted
• Mismatching reserve

TECH SCAM

Question 22

Define the term ‘pure matching’

2

Answer 22

• Pure matching involves structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the net outgo in respect of the liabilities under all circumstances.
• Req known timings and amounts which is not possible

Question 23

List 4 reasons why it is not normally possible to achieve pure matching

4

Answer 23

1. The timing or amount of asset proceeds or net liability outgo may be uncertain, e.g. due to options, discretionary benefits
2. Pure matching would involve buying excessive amounts of certain securities, which is likely to be prohibitive.
3. Pure matching would generally require risk-free zero-coupon bonds or strips with exactly the same term as the liabilities, which do not usually exist, or are too expensive.
4. Some liabilities are of such a long term that suitably long-dated assets do not exist

Question 24

Define the term ‘liability hedging’

4

Answer 24

• Liability hedging is where the assets are chosen in such a way as to perform in the same way as the liabilities. Liability hedging aims to select assets that perform EXACTLY like the liabilities across ALL main factors(mort,morb,interet etc).
• This is usually not achievable in practice. Instead, the investor might try to hedge liabilities with respect to specific factors.(Approx Liab hedge)
• Examples of this include currency, nature matching
• Hedging unit-linked liabilities can be fullly hedged as value of liabilities is implied by value of assets.

Question 25

Immunisation

2

Answer 25

• The investment of the assets in such a way that the present value of the assets minus the present value of the liabilities is immune to a general small change in the rate of interest.
• Can’t achieve matching can achieve immunization by ensuring PV Assets >= PV Liabilities

Question 26

7 Theoretical and practical problems with immunisation

Answer 26

• immunisation is generally aimed at meeting fixed monetary liabilities
• immunisation removes mismatching profits and losses apart from a second-order effect
• the theory relies upon small changes in interest rates
• the theory assumes a flat yield curve and level interest rate changes at all times
• in practice, the portfolio must be constantly rebalanced to maintain:
• equal discounted mean term
• greater spread of asset proceeds
  the theory ignores dealing costs
• Assets of a suitably long discounted mean term may not exist
• the timing of asset proceeds and liability outgo may not be known

Question 27

What is an ‘asset-liability model’

5

Answer 27

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

Question 28

How can the success of an investment strategy, determined using an asset -liability model, be monitored??

1

Answer 28

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