Chapter 16 - Asset liability management Flashcards
What are the two key principles of investment?
- A provider should select investments that are appropriate to the:
A CUNT
- the provider’s APPETITE for risk
- CURRENCY
- UNCERTAINTY of liabilities
- NATURE of liabilities
- TERM of liabilities
- Subject to the first constraint, the investments should be selected to maximize the overall return on the assets, where overall return includes both income and capital gains.
Four types of liabilities by nature
- Guaranteed in money terms
- Guaranteed in terms of an index
- Discretionary
- Investment - linked
Suggest a good asset match for liabilities guaranteed in money terms
Conventional bonds of an appropriate term.
However, an exact match is normally impossible since the timing of the asset proceeds is unlikely to coincide exactly with the liability outgo. Additionally, the available bonds may not be long enough in duration.
The bonds should be of high quality given that the benefit is guaranteed.
Derivatives could be used, but are generally considered expensive and exact matching may not always be possible.
Suggest a good asset match for liabilities guaranteed in terms of an index
Index linked bonds of an appropriate term.
However, these may not be available or they may not be linked to exactly the same index as the liabilities.
Alternatively, equities or property may provide a broad match.
Suggest a good match for discretionary liabilities
Assets expected to yield a high, real return, e.g. equities or property
However, the choice will also be affected by policyholders’ expectations and the provider’s appetite for risk.
List 4 reasons why it is not normally possible to achieve pure matching
- The timing or amount of asset proceeds or net liability outgo may be uncertain, e.g. due to options, discretionary benefits
- Pure matching would involve buying excessive amounts of certain securities, which is likely to be prohibitive.
- Pure matching would generally require risk-free zero-coupon bonds or strips with exactly the same term as the liabilities, which do not usually exist, or are too expensive.
- Some liabilities are of such a long term that suitably long-dated assets do not exist
Outline two methods by which a mismatching reserve might be determined
- Deterministic approach
- Select assets held that are equal to the value of the liabilities
- Recalculate the values of these assets and liabilities under stresses to economic factors such as interest rates
- If the stressed asset value is less than the stressed liability value, the difference is the mismatching reserve that should be held.
- Stochastic approach
- Perform a stochastic simulation of the markets in which funds are invested using an economic scenario generator.
- By inspecting the tails of the stochastic output, determine the mismatching reserve as the amount of the free assets that is needed in order to just prevent insolvency at the desired probability level.
Give examples of how the regulatory framework might limit what a provider wants to do in terms of investment
MET MECCA
- a requirement to MATCH assets and liabilities by currency
- restrictions on the maximum EXPOSURE to a single counterparty
- restrictions on the TYPES of assets the provider can invest in
- a requirement to hold a MISMATCHING reserve
- a limit to the EXTENT to which mismatching is allowed
- CUSTODIANSHIP of assets
- a requirement to hold a CERTAIN proportion of total assets in a particular class
- restrictions on the AMOUNT of any one asset used to demonstrate solvency may be restricted
What is an ‘asset-liability model’
An asset liability model is a deterministic or stochastic model that can be used to help an institutional investor set an investment strategy.
The model will have a specified objective with a measurable target that refers to assets and liabilities, a time horizon and a probability CI. For example, the value of the assets less the value of the liabilities must be greater than zero 95% of the time.
For a particular investment strategy, an asset-liability model projects asset proceeds and liability outgo cashflows into the future and values them.
The model is run and re-run, each time changing the investment strategy, until the stated objective is met.
The model should be dynamic, i.e. allow for correlations between asset and liability cashflows.
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.
7 Theoretical and practical problems with immunisation
MIL DRAFT
- immunisation removes MISMATCHING profits and losses apart from a second-order effect
- the theory relies upon small changes in INTEREST rates
- immunisation is generally aimed at meeting fixed monetary LIABILITIES
- the theory ignores DEALING costs
- in practice, the portfolio must be constantly REBALANCED to maintain:
– equal discounted mean term
– greater spread of asset proceeds - ASSETS of a suitably long discounted mean term may not exist
- the theory assumes a FLAT yield curve and level interest rate changes at all times
- the TIMING of asset proceeds and liability outgo may not be known
Investment-linked
This consists of benefits where the amount is directly determined by the value of the investments underlying the contracts
e.g unit-linked fund, where the liabilities are directly linked to the underlying value of the investments
Define the term ‘liability hedging’
Liability hedging is where the assets are chosen in such a way as to perform in the same way as the liabilities. Liability hedging aims to select assets that perform EXACTLY like the liabilities in ALL states.
This is usually not achievable in practice. Instead, the investor might try to hedge liabilities with respect to specific factors.
