Chapter 15-Asset liability management Flashcards
- What is a key decision for the provider of financial products regarding the investment in assets?
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.
- Discuss the main issues relating to the matching of assets to liabilities.
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.
- Discuss the circumstances in which additional capital may be required.
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.
- State the two overriding principles of investment for a provider of benefits on future uncertain events.
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.
- Describe what the practical work of the actuary involves when carrying out a matching exercise.
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.
- What two features of cashflows may be uncertain?
Both the timing and the amount of the cashflows may be known or unknown.
- List the main cashflows received and paid out by a company operating a privately-owned toll bridge, toll road or toll tunnel.
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).
- Outline the type and timing of the main cashflows of an insurance company.
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.
- How might an actuary deal with uncertainty about the amount or timing of cashflows?
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.
- Describe an annuity.
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.
- For how long are payments made under an immediate annuity?
For an immediate annuity, payments are made as long as the annuitant is alive.
- Describe the cashflows for the investor in an immediate annuity.
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.
- Describe the immediate annuity cashflows from the perspective of the annuity provider.
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.
- How is the annuity provider likely to invest the initial positive cashflow and what subsequent cash flows will this generate?
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.
- How is a repayment loan repaid?
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.
- Describe the cashflows of a repayment loan.
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.
- Explain how the breakdown of each payment into ‘interest’ and ‘capital’ changes significantly over the period of a repayment loan.
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.
- State the three components of ‘net liability outgo’.
The net liability outgo consists of:
benefit payments + expense outgo - premium / contribution income.
- Describe the four different categories into which the nature of a provider’s benefit outgo can be sub-divided.
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.
- Explain which category would be used to categorise a provider’s expense payments.
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.
- Explain which category would be used to categorise a provider’s premium / contribution income.
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.
- Discuss the matching implications (and any practical considerations) for liabilities that are guaranteed in money terms.
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.
- Discuss the matching implications (and any practical considerations) for liabilities that are guaranteed in terms of an index.
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.
- Discuss the matching implications (and any practical considerations) for liabilities that are discretionary.
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.
