CH15 - Asset-liability management Flashcards
The actual liability outgo in any year, or month, depends on (2)
- The monetary value of each of the constituents (συστατικά)
- The probability of it being received or paid out
4 categories of liability outgo created by nature/
Benefit payments subdivided into four types
- Guaranteed in money terms
This consists of benefit payments where the amount is specified in money terms.
2.Guaranteed in terms of a prices index or similar
This consists of benefits whose amount is directly linked to an index. - Discretionary
This consists of any payments that are payable at the discretion of the provider, e.g. future bonus payments under with-profit contracts or pension increases in excess of guaranteed amounts. - Investment-linked
This consists of benefits where the amount is directly determined by the value of the investments underlying the contracts.
Who can free assets or surplus benefit? (2)
- The provider’s clients, through higher benefits or lower premium / contribution rates
- Shareholders (if any), through higher dividends
Controls affecting investment strategy / regulation (8)
FIND ACRONYM
- 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 match assets and liabilities by currency
- Restrictions on the maximum exposure to a single counterparty
- Custodianship of assets
- A requirement to hold a certain proportion of total assets in a particular class
- A requirement to hold a mismatching reserve
- A limit on the extend to which mismatching is allowed at all
Pure matching
In its purest form matching of assets and liabilities involves structuring the flow of income and maturity proceeds from the assets so that they coincide precisely with the net outgo from the liabilities under all circumstances.
Unless risk-free zero-coupon bonds can be used it is rarely possible to achieve pure matching, although a close approximation to a perfect match may be possible for certain life insurance products, such as guaranteed income bonds.
Liability hedging
Liability hedging is where the assets are chosen in such a way as to perform in the same way as the liabilities.
In other words, hedging against all of the unpredictable changes in the liabilities that arise from unpredictable changes in the factors that influence liability values, e.g. interest rates, inflation levels, mortality experience.
Asset-liability models
An appropriate model to project the asset proceeds and liability outgo into the future can be used to help set an investment strategy to control the risk of failing to meet the objectives.
Asset-liability models can be either deterministic or stochastic.
Principles of investment
The principles of investment for a provider of benefits on future uncertain events can be stated as follows:
(1) A provider should select investments that are appropriate to the
- nature
- term
- currency
- uncertainty
of the liabilities, and
- the provider’s appetite for risk
(2) Subject to (1) the investments should also be selected so as to maximise the overall return on the assets, where overall return includes both income and capital.
Tip for exam question on cashflows
Make sure in an exam question that you have clear understanding of:
- from which party’s viewpoint you are examining the cashflows
- what the main cashflows are
- whether a cashflow is:
- positive or negative
- fixed or real
- known or unknown in amount
- known or unknown in timing and term
- the form of payments, i.e. lump sum or regular
The net liability outgo consists of (3)
Benefit payments
+ Expense outgo
- Premium / Contribution income
Expense outgo link
Expense payments tend to increase over time. The natural rate of increase is likely to fall somewhere between price and earnings inflation.
In addition, there are exceptional items which might be either expenditures or cost savings.
For investment purposes it is adequate to treat expenses as being linked to prices or earnings. Hence, they can be included with benefit payments guaranteed in terms of an index of prices or similar.
Premium / contribution income
Premium / contribution payments may:
- be fixed in monetary terms (negative benefit payments guaranteed in money terms)
- increase in line with an index (negative benefit payments guaranteed in terms of an index)
The existence of contracts or transactions where the client can vary the amount of premium each year does not invalidate this.
Approximate matching
Except for certain types of liability, it will probably be impossible in practice to find assets with proceeds that exactly match the expected liability outgo.
In particular, the terms of available fixed-interest securities may be much shorter than the corresponding liabilities, particularly when very long-term pension liabilities are involved.
The existence of options in either the liabilities or the assets also means that full cashflow matching cannot realistically be achieved.
Selecting assets when liabilities are investment linked
The benefits are guaranteed to the extend that their value can be determined at any time in accordance with a definite formula based on the value of a specific fund of assets or index.
The provider can avoid any investment matching problems by investing in the same assets as used to determine the benefits.
Replicating a market index may involve holding a large number of small holdings and thus be too costly. Companies might choose to use collective investment schemes or a derivative strategy to achieve this.
Deterministic approach to assess an appropriate provision to cover the mismatching of assets and liabilities (3)
- Assets are selected to match the value of liabilities exactly.
- Specified ‘time zero’ changes in the value of these assets and in economic factors such as interest rates are assumed, and the value of assets and liabilities recalculated.
- The difference (if the value of assets is less than the value of the liabilities) is the provision required, or the amount of free reserves needed to be set aside.