Chapter 15-Asset liability management

Question 1

1. What is a key decision for the provider of financial products regarding the investment in assets?

Answer 1

A key decision for the provider is whether or not to invest in such a way that the expected cashflows from the assets held match the expected cashflows from the liabilities it has taken on.

Question 2

2. Discuss the main issues relating to the matching of assets to liabilities.

Answer 2

If the decision is taken to match the assets to the liabilities then the optimal matched position will need to be determined. Given the uncertainties in the future cashflows of different liabilities, and the possible uncertainties associated with some assets, this is not a trivial exercise.

Question 3

3. Discuss the circumstances in which additional capital may be required.

Answer 3

If the decision is taken not to match the assets to the liabilities, then additional capital will need to be held to cover the possibility that there are insufficient assets to meet the liabilities when they fall due. Again, the determination of how much extra capital will be needed is not trivial.

Question 4

4. State the two overriding principles of investment for a provider of benefits on future uncertain events.

Answer 4

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 and 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.

Question 5

5. Describe what the practical work of the actuary involves when carrying out a matching exercise.

Answer 5

The practical work of the actuary usually involves the assessment and projection of future cashflows. These are sums of money which are paid or received at different times.

Question 6

6. What two features of cashflows may be uncertain?

Answer 6

Both the timing and the amount of the cashflows may be known or unknown.

Question 7

7. List the main cashflows received and paid out by a company operating a privately-owned toll bridge, toll road or toll tunnel.

Answer 7

For example, a company operating a privately-owned bridge, road or tunnel will receive toll payments. The company will pay out money for maintenance, debt repayment and for other management expenses.
From the company’s viewpoint the toll payments are positive cashflows (ie money received) while the maintenance, debt repayments and other expenses are negative cashflows (ie money paid out).

Question 8

8. Outline the type and timing of the main cashflows of an insurance company.

Answer 8

In some businesses, such as insurance companies, positive cashflows (premiums) are received before negative cashflows (claims and expenses) arise. These are available for investment, and will generate investment income, which is in turn another positive cashflow.

Question 9

9. How might an actuary deal with uncertainty about the amount or timing of cashflows?

Answer 9

Where there is uncertainty about the amount or timing of cashflows, one actuarial technique is to assign probabilities to both the amount and the existence of a cashflow.

Question 10

10. Describe an annuity.

Answer 10

An annuity provides a series of regular payments in return for a single premium. The conditions under which the annuity payments will be made will be clearly specified.

Question 11

11. For how long are payments made under an immediate annuity?

Answer 11

For an immediate annuity, payments are made as long as the annuitant is alive.

Question 12

12. Describe the cashflows for the investor in an immediate annuity.

Answer 12

The cashflows for the investor will be an initial negative cashflow, for the purchase of the annuity, followed by a series of smaller regular positive cashflows throughout annuitant’s lifetime.

Question 13

13. Describe the immediate annuity cashflows from the perspective of the annuity provider.

Answer 13

From the perspective of the annuity provider, there is an initial positive cashflow followed by an unknown number of regular known negative cashflows. These cashflows will comprise not only the annuity instalments, but also the provider’s expenses in administering the contract. The number of future negative cashflows depends on how long the annuitant lives.

Question 14

14. How is the annuity provider likely to invest the initial positive cashflow and what subsequent cash flows will this generate?

Answer 14

The provider is likely to invest the initial positive cashflow in the bond market (creating a negative cashflow), and will receive in return a number of interest and capital payments (positive cashflows) that will be expected to match the outgoings on expenses and annuity payments, and leave some surplus cash as profit.

Question 15

15. How is a repayment loan repaid?

Answer 15

A repayment loan is repayable by a series of amounts, each of which includes partial repayment of the loan capital in addition to the interest payment.

Question 16

16. Describe the cashflows of a repayment loan.

Answer 16

If the interest rate is fixed, the payments will be of fixed equal amounts, paid at regular known times. The cashflows are like those for an annuity except that the number of cashflows will usually be fixed, rather than related to survival.
There may be added complications if the interest rate is allowed to vary or if the loan can be repaid early. Additionally, it is possible that the regular repayments could be specified to increase (or decrease) with time. Such changes could be smooth or discrete.

Question 17

17. Explain how the breakdown of each payment into ‘interest’ and ‘capital’ changes significantly over the period of a repayment loan.

Answer 17

The first repayment will consist almost entirely of interest and will provide only a very small capital repayment. The final repayment will consist almost entirely of capital and will have only a small interest content. This is particularly relevant when interest and capital are taxed on different bases.

Question 18

18. State the three components of ‘net liability outgo’.

Answer 18

The net liability outgo consists of:
benefit payments + expense outgo - premium / contribution income.

Question 19

19. Describe the four different categories into which the nature of a provider’s benefit outgo can be sub-divided.

Answer 19

The benefit payments can be sub-divided into four types:
* Guaranteed in money terms - this consists of benefit payments where the amount is specified in money terms.
* Guaranteed in terms of an index of prices, earnings or similar - this consists of benefits whose amount is directly linked to an index. The index may not be a nationally published one.
* Discretionary - this consists of any payments that are payable at the discretion of the provider, eg 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.

Question 20

20. Explain which category would be used to categorise a provider’s expense payments.

Answer 20

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.

Question 21

21. Explain which category would be used to categorise a provider’s premium / contribution income.

Answer 21

Premium / contribution payments may be:
* fixed in monetary terms and hence can be thought of as negative benefit payments guaranteed in money terms
* or increase in line with an index and hence can be thought of as 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.

Question 22

22. Discuss the matching implications (and any practical considerations) for liabilities that are guaranteed in money terms.

Answer 22

A provider will want to invest so as to ensure that it can meet the guarantees. This means investing in assets which produce a flow of asset proceeds to match the liability outgo. This will involve taking into account the term of the liability outgo and the probability of the payments being made, so as to indicate the term of the corresponding assets.
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.
A best match is all that can normally be hoped for which may be achieved by investing in high quality fixed-interest bonds of a term suitable to match the expected term of the liability outgo.
Derivatives could be used to produce asset flows that match liability outgo. However, derivative strategies are generally expensive and exact matching may not always be possible.

Question 23

23. Discuss the matching implications (and any practical considerations) for liabilities that are guaranteed in terms of an index.

Answer 23

There are similar difficulties in matching liability outgo, as with liabilities guaranteed in monetary terms. The most suitable match is likely to be index-linked securities, where available, ideally chosen to match the expected term of the liability outgo.

Question 24

24. Discuss the matching implications (and any practical considerations) for liabilities that are discretionary.

Answer 24

If discretionary benefits are to be provided the main aim of the provider will be to maximise these and hence the investment strategy should therefore also aim to do that. This means investing in assets that will produce the highest expected return, subject both to the provider’s appetite for risk and also to the risk expectations of the client.

Question 25

25. Discuss the matching implications (and any practical considerations) for liabilities that are investment-linked.

Answer 25

The benefits are guaranteed to the extent that their value can be determined at any time in accordance with a definite formula based on the value of a specified 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.

Question 26

26. Outline the matching implications for liabilities that are denominated in a particular currency.

Answer 26

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

Question 27

27. What are the benefits of free assets or a surplus?

Answer 27

The existence of free assets or a surplus means that the provider can depart from the matching strategies outlined above. So there is less need to choose investments that are appropriate to the nature, term and currency of the liabilities but instead can look to improve the overall return on its assets. Improved returns would benefit its clients, through higher benefits or lower premium rates, and its shareholders (if any), through higher dividends.

Question 28

28. Discuss the way to determine the mismatching reserve.

Answer 28

A deterministic approach can be used to assess an appropriate provision to cover the mismatching of assets and liabilities, that is, to calculate a mismatching or resilience reserve:
* 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 is the provision required, or the amount of free reserves needed to be set aside.
The main technique used to determine how much of the free assets is needed is the same as that used to assess a risk-based capital requirement against market risk. This involves running a stochastic simulation of the markets in which funds are invested using an economic scenario generator. The capital required to just prevent insolvency at any desired probability can be determined by inspecting the tails of the output from the stochastic simulations.

Question 29

29. Discuss how the consideration of an institution’s free assets may affect its investment strategy in relation to guaranteed liabilities.

Answer 29

The amount of free assets required to maintain a delibrately mismatched policy is often too great for a company given the alternative uses of free assets, in particular financing new business growth or other new ventures. Therefore, in practice any guaranteed liability outgo is generally matched as closely as possible irrespective of the level of free assets.
With no free assets, if the assets supporting guaranteed benefits were invested in the assets with the highest expected return, the risk of insolvency would be too great. If there are free assets they could be used as a cushion to reduce the probability of becoming insolvent.
The extent to which free assets enable mismatching depends on:
* the size of free assets
* the volatility of returns on the assets held in respect of the guaranteed benefits
* the attitude to risk of the policyholders

Question 30

30. Discuss how the consideration of an institution’s free assets may affect its investment strategy in relation to discretionary liabilities.

Answer 30

It could be argued that matching assets to liabilities is irrelevant where there are discretionary benefits since a provider will want to invest in the securities with the highest expected return. On the other hand, although the benefits are discretionary, beneficiaries will expect to receive them and moreover will have expectations as to a minimum level. The provider will therefore want to make use of some of the free assets / surplus, or a limited matching strategy, to ensure that the probability of the discretionary benefits falling below a particular level stays within acceptable limits.

Question 31

31. Discuss how the consideration of a life insurance company’s free assets may affect its investment strategy in relation to investment-linked liabilities.

Answer 31

It could be argued that it is a reasonable use of the free assets / surplus to mismatch investment-linked benefits if by so doing 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.

Question 32

32. Outline the investment controls that the regulator might implement.

Answer 32

The regulatory framework within a country may limit what a provider would like to do in terms of investment. The following controls may be implemented:
* 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 specified class - for example government stock
* a requirement to hold a mismatching reserve
* a limit on the extent to which mismatching is allowed at all.

Question 33

33. Describe what is meant by matching a series of fixed outgoings and discuss whether it is likely to be possible in practice.

Answer 33

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. This requires the sensitivity of the timing and amount of both the asset proceeds and the net liability outgo to be known with certainty and to be identical with respect to all factors.
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.
Moreover, the relative price of the bonds chosen for the matching may be such as to deter all but the most dogmatic institutions. A further problem is that for some funds the term and size of the liabilities may be such that complete matching is unattainable because suitable assets are not available.

Question 34

34. Explain the thinking behind asset-liability modelling to determine an investment strategy.

Answer 34

An investor’s objectives will normally be stated with reference to both assets and liabilities. In setting an investment strategy to control the risk of failing to meet the objectives, a method that considers the variation in the assets simultaneously with the variation in the liabilities is required. This can be done by constructing a model to project the asset proceeds and liability outgo into the future.
The outcome of a particular investment strategy is examined with the model and compared with the investment objectives. The investment strategy is adjusted in the light of the results obtained and the process repeated until the optimum strategy is reached.
Modelling can either be deterministic or stochastic.

Question 35

35. Outline one advantage that undertaking a stochastic asset-liability modelling exercise provides to an investor.

Answer 35

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 levels 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. In practice, there is likely to be feedback between the model output and the setting of the objectives.

Question 36

36. How is the success of a strategy determined using an asset-liability model monitored?

Answer 36

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.

Question 37

37. Define the term ‘liability hedging’.

Answer 37

Liability hedging is where the assets are chosen in such a way as to perform in the same way as the liabilities.

Question 38

38. Provide examples of how an investor can achieve ‘approximate liability hedging’.

Answer 38

Familiar forms of hedging include matching by currency and the consideration of the 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.

Question 39

39. Explain how investors can choose assets to hedge unit-linked liabilities.

Answer 39

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.