Ch 16: Asset-liability management 2 Flashcards
Principles of investment
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)
In practice, the actual liability outgo depends on (2)
- Monetary value of each of the constituents
- Probability of it being received or paid out
Liability outgo can be split by nature into 4 categories:
- 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)
Investment-linked benefit payments
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.
Currency (i.t.o. asset-liability matching)
Liabilities denominated in a particular currency should be matched by assets in the same currency, so as to reduce any currency risk.
Regulation (i.t.o. investing assets)
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
Immunisation
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.
Discretionary benefits
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.
Appropriate assets for liabilities guaranteed in money terms.
Fixed interest assets.
Approaches to matching liabilities guaranteed in money terms
- Pure cashflow matching
- Approximate matching:
~ Immunisation
~ Liability hedging
3 Conditions of immunisation
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.
Limitation of immunisation
Provides protection against parallel yield curve shifts, but not against twists or other non-parallel movements.
Appropriate assets for liabilities guaranteed in terms of an index
Index-linked securities, where available
If not available:
- Equity type assets
- Assets expected to produce a real return
Appropriate assets for discretionary benefits liabilities
Aim is to maximise benefits and/or meet expectations.
Investing to produce highest expected return and/or smooth returns.
Net liability outgo consists of
E(net liability outgo)
E(Benefit payments)
+ E(Expense outgo)
- E(Premium/contribution income)
Benefits, expenses, guarantees
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
Workings of a mismatching reserve
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.
Matching
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.
What level of matching is optimal?
Achieving the required degree of certainty at the lowest cost, while satisfying the regulator and other investment objectives.
- Minimise cost
- Maximise return
Mismatching
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)
Appropriateness of mis-matching
- Guaranteed benefits (less flexibility to mismatch)
- Discretionary benefits (more flexibility to mismatch)
- Investment linked benefits
- Banks
How is the desired level of free assets calculated?
- 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
Why is asset-liability management important?
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)
3 Common problems with the precise matching of assets to liabilities in practice:
- 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
Techniques:
Pure matching
Approximate matching
- Including immunisation
Liability hedging
- Approximate liability hedging
- Full liability hedging
Modelling flows
- Deterministic or stochastic
Understanding of cashflows
- 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
Pure matching
- Cashflows from assets are matched exactly in terms of timing and amount with the liability outgo
- Timing and amount are known with certainty
Approximate matching
- 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)
Immunisation
Assumptions
Limitations
Liability hedging
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)
4 Actuarial techniques for determining an investment strategy
- Pure/exact matching
- Liability hedging
~ Full hedging
~ Approximate hedging (immunisation) - Asset liability models
- Mean-variance with reference to liabilities
