Chapter 16: Asset-liability management Flashcards
What do the principles of investments state ?
- 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)
Optimal matched position
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
Net liability outgo
expenses outgo
+
Benefits payment (liabilty)
-
Premiums (Contribution income)
Types of benefit payments
- Guaranteed in monetary terms
- Guaranteed in real terms (index linked)
- Investment linked
- Discretionary
Types of premium payments
- Fixed in monetary terms
- Increase in line with an index
Matching liabilities guaranteed in money terms
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.
Matching liabilities guaranteed in terms of a price index or similar
- Likely to be index-linked securities
- In their absence, a substitute would be assets that are expected to provide real returns
Matching liabilities that are discretionary
- Persue the highest expected return, subject to the risk appetite of the provider and the client
Matching investment linked liabilities
- Invest in the assets that are in the same assets used to determine benefits
What influences a provider’s decision on the balance between risk and return
- Free assets
- Regulatory requirments
Deterministic approach to calculate mismatching or resilience reserve
- 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
Stochastic approach to determining the mismatching reserve
- 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
Constraints to using free assets to support a mismatching strategy
Free assets could be used for expansion or other investments
Some controls controls that could be implemented to limit what a provider may be able to do in terms of investment
- 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
Pure matching
Choosing assets that coincide with liability cashflow exactly
Liability hedging
Assets are chosen as to behave in a similar way to liabilities
Types of liability hedging - with explanations
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
Immunisation
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
Duration
Weighted-average of the time to payment, weighted by the present value of the cashflows
Convexitvity
Sensitivity of the volatility of the cashflow to changes in the interest rate
Volatility
Duration/(1+i)
Conditions for immunisation
- PV of assets equal PV liabilities
- Durations of assets and liabilities are equal
- Convexivity of assets (spread) > convexivity of liabilities
Limitations of classical immunisation theory
- 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.
