Ch 16: Asset-liability management 2

Question 1

Principles of investment

Answer 1

A provider should select investments that are appropriate to the:
- nature
- term
- currency
- uncertainty (amount and timing)
- magnitude
- size
of the liabilities
and the provider’s appetite for risk

Subject to this, the investments should be selected to maximise the overall return (income plus capital) on the assets.

Desired degree of matching liabilities is dependent on:
- Free assets available (capacity to take on risk)
- The desired risk/return profile (a matched strategy can result in lower expected returns)
- The asset choices that are available (it may not be practical or possible to match exactly)
- Regulatory requirements
- Mismatching reserve available
(trade-off between mismatching reserve and free assets)

Question 2

In practice, the actual liability outgo depends on (2)

Answer 2

• Monetary value of each of the constituents
• Probability of it being received or paid out

Question 3

Liability outgo can be split by nature into 4 categories:

Answer 3

• Guaranteed in money terms
  (zero coupon government bonds)
• Guaranteed in terms of a price index or similar (index linked government bonds)
• Discretionary (with-profits/bonuses/dividends) (take an aggressive approach to maximise profits
• Investment linked (unit-linked benefits)

Question 4

Investment-linked benefit payments

Answer 4

Appropriate assets are those which replicate, or closely approximate the index.
Any free assets may be used to maximise returns with any profit benefiting the provider. However, regulation may disallow mismatching.

Question 5

Currency (i.t.o. asset-liability matching)

Answer 5

Liabilities denominated in a particular currency should be matched by assets in the same currency, so as to reduce any currency risk.

Question 6

Regulation (i.t.o. investing assets)

Answer 6

Types of assets
- Restrictions on the types of assets that a provider can invest in
- Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
- A requirement to hold a certain proportion of total assets in a particular class, for example, a government bond stock.

Mismatching
- A requirement to match assets and liabilities by currency.
- A requirement to hold a mismatching reserve.
- A limit on the extent to which mismatching is allowed at all.
- Restrictions on the maximum exposure to a single counterparty
- Might require custodianship of assets

Question 7

Immunisation

Answer 7

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.

Question 8

Discretionary benefits

Answer 8

Payments that are payable at the discretion of the provider.

For example, future bonus payments under with-profit contracts or pension increases in excess of guaranteed contracts.

Question 9

Appropriate assets for liabilities guaranteed in money terms.

Answer 9

Fixed interest assets.

Question 10

Approaches to matching liabilities guaranteed in money terms

Answer 10

• Pure cashflow matching
• Approximate matching:
  ~ Immunisation
  ~ Liability hedging

Question 11

3 Conditions of immunisation

Answer 11

1) The present value of the liability-outgo and asset-proceeds are equal.
2) The (discounted) mean term of the value of the assets-proceeds must equal the discounted mean term of the value of the liability-outgo.
3) The spread (or convexity) about the mean of the value of the asset-proceeds should be greater than the spread of the value of the liability-outgo.

Question 12

Limitation of immunisation

Answer 12

Provides protection against parallel yield curve shifts, but not against twists or other non-parallel movements.

Question 13

Appropriate assets for liabilities guaranteed in terms of an index

Answer 13

Index-linked securities, where available

If not available:
- Equity type assets
- Assets expected to produce a real return

Question 14

Appropriate assets for discretionary benefits liabilities

Answer 14

Aim is to maximise benefits and/or meet expectations.

Investing to produce highest expected return and/or smooth returns.

Question 15

Net liability outgo consists of

Answer 15

E(net liability outgo)

E(Benefit payments)
+ E(Expense outgo)
- E(Premium/contribution income)

Question 16

Benefits, expenses, guarantees

Answer 16

Benefits
- Guaranteed in monetary terms
(zero coupon government bond)
- Guaranteed in terms of a price index
or similar (inflation-linked bonds, equities)
- Discretionary
- Investment linked

Expenses
- Real/inflation linked (price or earnings inflation)

Premiums
- Fixed in monetary terms
- Linked to an index

Question 17

Workings of a mismatching reserve

Answer 17

The regulations are usually framed so that the more a company decides to invest in riskier assets with a higher expected return, the higher is any resulting reserve.

This increases the value of the liabilities and reduces the available free assets/surplus.

Question 18

Matching

Answer 18

Involves structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the outgo in respect of the liabilities under all circumstances.

Question 19

What level of matching is optimal?

Answer 19

Achieving the required degree of certainty at the lowest cost, while satisfying the regulator and other investment objectives.
- Minimise cost
- Maximise return

Question 20

Mismatching

Answer 20

Ability to depart from a matched position to improve returns, for the benefit of either the shareholder (higher dividends) and/or policyholder/client (lower premium or higher benefits)

Question 21

Appropriateness of mis-matching

Answer 21

• Guaranteed benefits (less flexibility to mismatch)
• Discretionary benefits (more flexibility to mismatch)
• Investment linked benefits
• Banks

Question 22

How is the desired level of free assets calculated?

Answer 22

• Dependent on how much is needed to cover a 1 in 200 event.
• Could be determined to prevent the probability of ruin by 99.5%
• Deterministic scenario testing
• Stochastic modelling
• Depends on how the free assets are invested

Question 23

Why is asset-liability management important?

Answer 23

To protect stakeholders interests:
~ To meet promises to policyholders/customers - reputation/confidence
- To stay in business
- To meet regulatory requirements
- To maximise return/profit (subject to the above)

Question 24

3 Common problems with the precise matching of assets to liabilities in practice:

Answer 24

• Uncertain in the timing and/or amount of either assets or liabilities
• Assets of long enough term may not exist
• Income from the assets may exceed liability outgo in early years

Question 25

Techniques:

Answer 25

Pure matching

Approximate matching
- Including immunisation

Liability hedging
- Approximate liability hedging
- Full liability hedging

Modelling flows
- Deterministic or stochastic

Question 26

Understanding of cashflows

Answer 26

• From whose perspective? +ve or -ve
• Identify main cashflows
• Fixed or real
• Known or unknown amount
• Known or unknown in term and timing
• Frequency (single payment or regular)
• Probability of cashflows

Question 27

Pure matching

Answer 27

• Cashflows from assets are matched exactly in terms of timing and amount with the liability outgo
• Timing and amount are known with certainty

Question 28

Approximate matching

Answer 28

• Fixed interest assets with the desired term may not be available
• Income from assets may be different to liability outgo
• Goal: PV(assets) - PV(liabilities) is immune to small changes in the interest rate

Select assets such that:
1) EPV of assets proceeds = EPV of liability outgo
2) Discounted mean term (expected asset proceeds) = Discounted mean term ( Expected liability outgo)
3) The spread/convexity about the DMT (expected asset proceeds) > The spread/convexity about the DMT (expected liability outgo)

Question 29

Immunisation

Answer 29

Assumptions

Limitations

Question 30

Liability hedging

Answer 30

Where the assets are chosen in such a way as to perform in the same way as the liabilities

Full liability hedging
- The value of the liability is implied by the value of the assets

Approximate liability hedging
- Select assets that perform in the same way as the liabilities (currency, real or nominal)

Question 31

4 Actuarial techniques for determining an investment strategy

Answer 31

• Pure/exact matching
• Liability hedging
  ~ Full hedging
  ~ Approximate hedging (immunisation)
• Asset liability models
• Mean-variance with reference to liabilities