CH15 - Asset-liability management Flashcards

1
Q

The actual liability outgo in any year, or month, depends on (2)

A
  1. The monetary value of each of the constituents (συστατικά)
  2. The probability of it being received or paid out
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2
Q

4 categories of liability outgo created by nature/

Benefit payments subdivided into four types

A
  1. 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.
  2. 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.
  3. Investment-linked
    This consists of benefits where the amount is directly determined by the value of the investments underlying the contracts.
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3
Q

Who can free assets or surplus benefit? (2)

A
  1. The provider’s clients, through higher benefits or lower premium / contribution rates
  2. Shareholders (if any), through higher dividends
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4
Q

Controls affecting investment strategy / regulation (8)

FIND ACRONYM

A
  1. Restrictions on the types of assets that a provider can invest in
  2. Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
  3. A requirement to match assets and liabilities by currency
  4. Restrictions on the maximum exposure to a single counterparty
  5. Custodianship of assets
  6. A requirement to hold a certain proportion of total assets in a particular class
  7. A requirement to hold a mismatching reserve
  8. A limit on the extend to which mismatching is allowed at all
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5
Q

Pure matching

A

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.

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6
Q

Liability hedging

A

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.

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7
Q

Asset-liability models

A

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.

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8
Q

Principles of investment

A

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.

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9
Q

Tip for exam question on cashflows

A

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
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10
Q

The net liability outgo consists of (3)

A

Benefit payments
+ Expense outgo
- Premium / Contribution income

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11
Q

Expense outgo link

A

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.

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12
Q

Premium / contribution income

A

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.

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13
Q

Approximate matching

A

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.

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14
Q

Selecting assets when liabilities are investment linked

A

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.

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15
Q

Deterministic approach to assess an appropriate provision to cover the mismatching of assets and liabilities (3)

A
  1. Assets are selected to match the value of liabilities exactly.
  2. 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.
  3. 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.
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16
Q

Maximising returns for assets that match guaranteed benefits

A

If the assets supporting guaranteed benefits are invested to produce the highest expected return without any thought to the nature of the liabilities, the probability that the asset proceeds will be inadequate to meet the liabilities will be high.
If there are free assets they can be used to make up the shortfall in these circumstances.
If there are no free assets, or not enough free assets, this approach will lead to insolvency.

17
Q

Maximising returns for assets that match discretionary benefits

A

It could be argued that matching assets to liablities is irrelevant where there are discretionary benefits, since the provider will want to invest in the securities with the highest expected return.
On the other hand, although the benefits are fully discretionary, beneficiaries will expect to receive something and moreover will have expectations as to a minimum level.

18
Q

Maximising returns for assets that match investment-linked benefits

A

It could be argued that it is reasonable use of the free assets / surplus to mismatch investment - linked benefits if by doing so the company can expect to achieve a higher return.
If this is done any return achieved above that on the ‘matched’ assets will not accrue to the beneficiaries of the investment-linked contracts but to the provider.
In many territories, mismatching investment-linked benefits is disallowed by law or regulation.

19
Q

Describe the function and services provided by a custodian

A

A custodian holds investments on behalf of an investor and is able to account independently for any financial transactions.
The principal function of custody is to ensure that financial instruments are housed under a proper system that permits investment for proper purposes with proper authority.
Custodians are usually banks or other regulated institutions. Custodians offer not only custody of documents, but also a range of services such as:
- income collection
- tax recovery
- cash management
- securities settlement
- foreign exchange
- stock lending
Also, the custodian will often exercise voting rights on behalf of the client.

20
Q

Approximate liability hedging

A

Familiar forms of hedging include matching by currency and the consideration of real or nominal nature of liabilities when determining the choice of assets.
However, these examples relate only to specific characteristics of the liabilities, whereas liability hedging aims to select assets that perform exactly like the liabilities in all events.

21
Q

Full liability hedging

A

When choosing assets to hedge unit-linked liabilities, the normal approach is to establish a portfolio of assets, determine a unit price by reference to the value of the asset portfolio, and then use this price to value the units and hence the liabilities.

22
Q

Advantages of stochastic modelling

A

An advantage of stochastic modelling is that it encourages investors to formulate explicit objectives. The objectives should include a quantifiable and measurable performance target, defined performance horizons and quantified confidence intervals for achieving the target.
For a financial institution, the objectives might be specified in terms of the results of a valuation carried out at a specified time in the future.
The success of the strategy is monitored by means of regular valuations.