Chapter 16: Asset-Liability Management Flashcards

1
Q

What are the two key principles of investment?

A
  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 the first constrain, the investments should be selected to maximize the overall return on the assets, where overall return includes both income and capital gains.
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2
Q

List the features that might be covered when asking to describe a cashflow, as well as the typical cashflows for insurance products

A
  1. Direction (positive or negative)
  2. Size
  3. Nature
  4. Term and timing
  5. Currency
  6. Certainty (of both timing and amount)
Purchase
Claim Benefits
Surrender benefits
Investments
Expenses incl commission, initial, admin, claims handlings
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3
Q

Describe the cashflows on a single life immediate annuity from the perspective of the provider

A

Single premium - an initial lump sum positive cashflow

Annuity payments - a regular series of negative amounts. The timing of these cashflows are usually known. The amount will usually be known either in monetary or real terms. The total term of payment is unknown as it will depend on how long the annuitant lives.

Investment - an initial negative cashflow, then a series of positive cashflows in the form of interest and capital payments from the bonds in which the provider has invested.

Expenses - an initial lump sum negative cashflow to cover commission and set up expenses. This is followed by a regular stream of negative cashflows to cover the administration of paying benefits. These can be expected to increase over time in line with a mixture of price / wage inflation.

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4
Q

Describe the cashflows on a term assurance from the perspective of the provider

A

Premiums - a regular series of positive payments. The timing is usually known. The amount is usually known and fixed. The total term of premium payment is unknown as it will depend on when/if the policyholder dies. A variation is a single premium contract.

Benefit - a lump sum negative cashflow paid on the death of the policyholder. The timing is unknown. The amount of the sum assured is known. If the policyholder survives then there will be no benefit cashflow.

Investment - a series of positive cashflows in the form of income and gains from the investments in which the provider has invested ( and negative cashflows when the investments are initially purchased)

Expenses - an initial lump sum negative cashflow to cover commission and set-up expenses. A termination lump sum negative cashflow is payable on death to cover claims handling expenses. There will also be regular negative cashflows to cover administration expenses.

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5
Q

Describe how the cashflows from the perspective of the provider on a (without-profit) endowment assurance differ from those on a term assurance

A

There will be an additional lump sum negative cashflow on the maturity date of the contract if the policyholder survives until the end. The amount will be known.

There may be a lump sum negative cashflow if the policyholder surrenders the contract before the end of the contract term. The amount may be known or unknown, depending on the terms of the contract.

For a given sum assured, the premiums will be greater than for a term assurance policy.

Investment income and gains will also be greater.

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6
Q

Describe the cashflows on a repayment loan from the perspective of the provider

A

Loan amount - an initial lump sum negative cashflow equal to the loan amount

Interest and capital payments - a regular series of positive payments. Each payment comprises part interest, part capital. The capital (interest) component increases (decreases) over the period of the loan. The total amount may be fixed, variable, or specified to increase / decrease over the period of the loan. The timing and the total term of payments is usually known, unless the loan is repaid early or the borrower defaults.

Expenses - an initial lump sum negative cashflow to cover commission and set - up expenses. This is followed by a regular stream of negative cashflows to cover the administration of collecting premiums. These can be expected to increase over time in line with a mixture of price / wage inflation.

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7
Q

Describe how the cashflows on an interest only loan differ from those on a repayment loan from the perspective of the provider

A

For an interest only loan the regular payments received by the provider comprise only interest, not interest and capital. The amount may be fixed or variable.

There will be an additional lump sum positive cashflow: the capital repayment. The amount is usally known and equal to the initial loan amount. The timing is usually known unless the borrower dies, repays the loan early or defaults.

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8
Q

Describe the cashflows on a motor insurance contract from the perspective of the provider

A

Premiums - a lump sum positive cashflow paid at the start of the year or a regular series of positive monthly cashflows paid throughout the year. The amount and timing of the cashflows are usually known unless endorsements are made to the policy throughout the year or the policyholder dies.

Claims - negative cashflows to cover the costs of claims. There may be more than one claim payment in respect of the period of cover and there may be reporting and settlement delays. The timing and amount of the cashflows are unknown.

Investment - a series of positive cashflows in the form of income and gains from the investments in which the provider has invested ( and negative cashflows when the investments are initially purchased)

Expenses - an initial lump sum negative cashflow to cover commission and set up expenses. Negative cashflows incurred between claim reporting and settlement to cover claim expenses.

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9
Q

Define the ‘net liability OUTGO’ for a provider

A

Benefits (or claims)
+ expenses
- contributions (or premium) income

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10
Q

Four types of liabilities by nature

A
  1. Guaranteed in money terms
  2. Guaranteed in terms of an index
  3. Discretionary
  4. Investment - linked
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11
Q

Suggest a good asset match for liabilities guaranteed in money terms

A

Conventional bonds of an appropriate term.

However, an exact/pure 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.

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12
Q

Suggest a good asset match for liabilities guaranteed in terms of an index

A

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.

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13
Q

Suggest a good match for discretionary liabilities

A

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.

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14
Q

Suggest a good asset match for investment-linked liabilities

A

The provider can avoid any investment mismatching problems by investing in the same assets as used to determine the benefits.

If this requires replicating a market index then it may involve holding a large number of small holdings and thus be too costly. Companies might choose to use CISs that track the investment or a derivative strategy to do this.

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15
Q

List 4 reasons why it is not normally possible to achieve pure matching

A
  1. The timing or amount of asset proceeds or net liability outgo may be uncertain, e.g. due to options, discretionary benefits
  2. Pure matching would involve buying excessive amounts of certain securities, which is likely to be prohibitive.
  3. 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.
  4. Some liabilities are of such a long term that suitably long-dated assets do not exist
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16
Q

Explain how the existence of free assets affects the investment strategy of an insurance company

A
  1. Free assets act as a cushion against adverse investment experiences.
  2. With free assets, it may be possible to depart from the matched strategies suggested previously in pursuit of higher expected returns (and hence higher benefits, lower premiums or higher profits)
  3. However, there need to be sufficient free assets since mismatching and investing in higher risk / higher return assets increases the risks of not meeting guaranteed liabilities and of insolvency.
  4. There may be competing uses of free assets which limit the potential to mismatch
  5. In some territories, the mismatching of investment-linked liabilities may not be permitted by law or by regulation.
17
Q

Outline two methods by which a mismatching/resilience reserve might be determined

A
  1. 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.
  2. 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.
18
Q

Give 8 examples of how the regulatory framework might limit what a provider wants to do in terms of investment

A

TECH SCAM

Types of assets the provider can invest in
Extent to which mismatching is allowed
Currency matching requirement
Hold certain assets

Single counterparty maximum exposure
Custodianship of assets
Amount of any one assets used to demonstrate solvency may be restricted
Mismatching reserve

19
Q

Define the term ‘pure matching’

A

Pure matching involves structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the net outgo in respect of the liabilities under all circumstances.

20
Q

Define the term ‘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. 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.

Examples of this include currency matching and hedging unit-linked liabilities

21
Q

Describe what is meant by “‘unit-linked liability’ hedging”

A

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.

The values of the liabilities are IMPLIED by the values of the asset

22
Q

What is an ‘asset-liability model’

A

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.

23
Q

How can the success of an investment strategy, determined using an asset-liability model, be monitored??

A

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.

24
Q

Immunisation

A

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/unresponsive to a general small change in the rate of interest

25
Q

7 Theoretical and practical problems with immunisation

A
  • immunisation is generally aimed at meeting fixed monetary liabilities
  • immunisation removes mismatching profits and losses apart from a second-order effect
  • the theory relies upon small changes in interest rates
  • the theory assumes a flat yield curve and level interest rate changes at all times
  • in practice, the portfolio must be constantly rebalanced to maintain:
  • equal discounted mean term
  • greater spread of asset proceeds
    the theory ignores dealing costs
  • Assets of a suitably long discounted mean term may not exist
  • the timing of asset proceeds and liability outgo may not be known
26
Q

Advantage of Stochastic Modelling in determining an investment strategy.

A
  1. Encourages investors to formulate explicit objectives.

These objectives should be measurable, within defined performance horizons and confidence levels.