Chapter 16: Asset-liability management

Question 1

What do the principles of investments state ?

Answer 1

• Investments should be chosen that are appropriate for liabilities (Nature, term, currency and level of uncertainty) and reflect the risk appetite of the investor
• Subject to the above, investments should be chosen to maximise returns (overall return includes both income and capital)

Question 2

Optimal matched position

Answer 2

Satisfies the provider’s required degree of certianty in
* meeting the liabilities for the least cost,
* taking into account regulatory requirements and other investment objectives

Difficult considering the uncertainties in both assets and liabilities

Question 3

Net liability outgo

Answer 3

expenses outgo
+
Benefits payment (liabilty)
-
Premiums (Contribution income)

Question 4

Types of benefit payments

Answer 4

• Guaranteed in monetary terms
• Guaranteed in real terms (index linked)
• Investment linked
• Discretionary

Question 5

Types of premium payments

Answer 5

• Fixed in monetary terms
• Increase in line with an index

Question 6

Matching liabilities guaranteed in money terms

Answer 6

Pure matching
* Invest in assets that meet the liability outgo.
* In timing and amount

Aproximate matching
* Impossible to find assets that exactluy match
* Invest in high quality fixed interest bonds that match the expected term. Might not be possible to match the timing
* Deriviatives could be used but usually expenses and exact matching might not be possible.

Question 7

Matching liabilities guaranteed in terms of a price index or similar

Answer 7

• Likely to be index-linked securities
• In their absence, a substitute would be assets that are expected to provide real returns

Question 8

Matching liabilities that are discretionary

Answer 8

• Persue the highest expected return, subject to the risk appetite of the provider and the client

Question 9

Matching investment linked liabilities

Answer 9

• Invest in the assets that are in the same assets used to determine benefits

Question 10

What influences a provider’s decision on the balance between risk and return

Answer 10

• Free assets
• Regulatory requirments

Question 11

Deterministic approach to calculate mismatching or resilience reserve

Answer 11

• Assets are selected to match the 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 liabbilities are calculated
• Difference is then reserved 2

Question 12

Stochastic approach to determining the mismatching reserve

Answer 12

• Similar to risk-based capital requirement against market risk.
• Involves running a stochastic simulation of the markets in which funds are invested using an economic scenario generator
• The capital required to prevent insolvency at any probability level is determined by inspecting the tails of the output from the stochastic simulations

Question 13

Constraints to using free assets to support a mismatching strategy

Answer 13

Free assets could be used for expansion or other investments

Question 14

Some controls controls that could be implemented to limit what a provider may be able to do in terms of investment

Answer 14

• 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 the assets
• Arequirement to hold a certain proportion of the total assets in a particular class.
• A requirement to hold a mismatching reserve
• Alimit on the extent to which mismatching is allowed at all

Question 15

Pure matching

Answer 15

Choosing assets that coincide with liability cashflow exactly

Question 16

Liability hedging

Answer 16

Assets are chosen as to behave in a similar way to liabilities

Question 17

Types of liability hedging - with explanations

Answer 17

Approximate liability hedging - When hedging liabilities w.r.t all factors is not possible, hedge with respect to specific factors

Full liability hedging - Hedging with respect to all factors - possible for unit linked liabilities

Question 18

Immunisation

Answer 18

The investment of assets in such a way that the present value of the assets less the liabilities is immune to a general small change in the interest rate

Question 19

Duration

Answer 19

Weighted-average of the time to payment, weighted by the present value of the cashflows

Question 20

Convexitvity

Answer 20

Sensitivity of the volatility of the cashflow to changes in the interest rate

Question 21

Volatility

Answer 21

Duration/(1+i)

Question 22

Conditions for immunisation

Answer 22

• PV of assets equal PV liabilities
• Durations of assets and liabilities are equal
• Convexivity of assets (spread) > convexivity of liabilities

Question 23

Limitations of classical immunisation theory

Answer 23

• Typically aimed at liabilities fixed in monetary terms
• Possibility of mismatching profits as well as losses is removed apart from a small second order effect
• Theory applies to small changes in interest rates
• Theory assumes a flat yield curve and requires the same change in interest rates at all terms
• In practice the portfolio must be rearranged constantly to maintain the correct balance of: equal durations and greater spread of asset proceeds
  The theory also ignored 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.