Chapter 16: Asset-liability management

Question 1

Principles of investment

Answer 1

A provider should select investments that are appropriate to the:
- nature
- term
- currency
- uncertainty
of the liabilities
- and the provider's appetite for risk.

Subject to this, the investments should be selected to maximise the overall return (income plus capital) on the assets.

Question 2

In practice, the actual liability outgo depends on (2)

Answer 2

• monetary value of each of the constituents

- probability of it being received or paid out.

Question 3

Liability outgo can be split by nature into 4 categories:

Answer 3

• guaranteed in money terms
• guaranteed in terms of a prices index or similar
• discretionary (with-profit discretionary benefits)
• investment-linked (unit-linked benefits)

Question 4

Investment-linked benefit payments

Answer 4

Appropriate assets are those which replicate, or closely approximate the index.
Any free assets may be used to maximise returns with any profit benefiting the provider. However, regulation may disallow mismatching.

Question 5

Currency (i.t.o asset-liability matching)

Answer 5

Liabilities denominated in a particular currency should be matched by assets in the same currency, so as to reduce any currency risk.

Question 6

Regulation (i.t.o. investing assets)

Answer 6

• Types of assets:

• 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 hold a certain proportion of total assets in a particular class, for example a government stock.

• Mismatching:

• A requirement to match assets and liabilities by currency.
• A requirement to hold a mismatching reserve.
• A limit on the extent to which mismatching is allowed at all.
• Restrictions on the maximum exposure to a single counterparty
• Might require custodianship of assets.

Question 7

Immunisation

Answer 7

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.

Question 8

Discretionary benefits

Answer 8

Payments that are payable at the discretion of the provider.

For example, future bonus payments under with-profit contracts or pension increases in excess of guaranteed contracts.

Question 9

Appropriate Assets for liabilities guaranteed in money terms

Answer 9

fixed interest assets.

Question 10

Approaches to matching liabilities guaranteed in money terms

Answer 10

• Pure Cashflow Matching
• Approximate matching:
  ……- Immunisation
  ……- Liability hedging

Question 11

3 Conditions of Immunization

Answer 11

1. The present values of the liability-outgo and asset proceeds are equal.
2. The (discounted) mean term of the value of the asset-proceeds must equal the mean term of the value of the liability-outgo
3. The spread (or convexity) about the mean term of the value of the asset-proceeds should be greater than the spread of the value of the liability-outgo.

Question 12

Limitation of Immunization

Answer 12

Provides protection against parallel yield curve shifts, but not against twists or other non-parallel movements.

Question 13

Appropriate Assets for liabilities guaranteed in terms of an index

Answer 13

Index-linked securities, where available

If not available:

• equity type assets
• assets expected to produce a real return

Question 14

Appropriate assets for discretionary benefits liabilities

Answer 14

Aim is to maximise benefits and/or meet expectations.

Investing to produce highest expected return and/or smooth returns.

Question 15

Net liability outgo consists of

Answer 15

benefit payments
+ expense outgo
- premium / contribution income

Question 16

Workings of a mismatching reserve

Answer 16

The regulations are usually framed so that the more a company decides to invest in riskier assets with a higher expected return, the higher is any resulting reserve.
This increases the value of the liabilities and reduces the available free assets/surplus.

Question 17

Matching

Answer 17

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

Question 18

3 Common problems with the precise matching of assets to liabilities in practice:

Answer 18

• uncertain in the timing and/or amounts of either assets or liabilities
• assets of long enough term may not exist
• income from the assets may exceed liability outgo in the early years.

Question 19

Liability hedging

Answer 19

Where the assets are chosen in such a way as to perform in the same way as the liabilities.

Question 20

7 Theoretical and practical problems with immunisation

Answer 20

• 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

Question 21

4 Actuarial techniques for determining an investment strategy

Answer 21

• Pure/exact matching
• Liability hedging:
  ….• Full Hedging
  ….• Approximate hedging (immunisation)
• Asset liability models
• Mean-variance with reference to liabilities

Question 22

Pure matching

Answer 22

• Asset proceeds coincides precisely with net liability outgo
• Sensitivity of timing & amounts need to be known with certainty

Question 23

2 Restrictions of pure matching

Answer 23

• Rarely possible in practice (except for fixed liabilities)
• Suitable assets might not be available / prohibitively expensive

Its still useful as a benchmark position though

Question 24

Liability hedging / matching

Answer 24

Liabilities ‘behave’ (in terms of values, returns, CFs) in the same way as assets with regards to all relevant factors, eg:

• interest rates,
• inflation,
• currency,
• decrements, etc.

Question 25

Full hedging in practice

Answer 25

In practice its achievable in limited circumstances (E.g. unit-linked liabilities):

• Unit price is determined by reference to the portfolio
• Can be difficult if benchmark is determined externally
• Derivatives are extensively used

Question 26

Approximate hedging / matching

Answer 26

Hedging with regards to specific factors:

• Nature (fixed/real)
• Term
• Currency
• Immunisation (interest rates)

Question 27

Asset-liability models

Answer 27

An asset-liability model is a tool used by an investor to help determine what assets to invest in given a particular objective or objectives.

Question 28

Workings of an asset-liability model

Answer 28

The outcome of a particular investment strategy is examined with the model and compared with the investment objectives.

The investment strategy is adjusted in the light of the results obtained and the process is repeated until the optimum strategy is reached.

Question 29

Advantage of an asset-liability model

Answer 29

It encourages investors to formulate explicit objectives.

Question 30

Asset-liability model:

The investment objectives should include (3)

Answer 30

• A quantifiable and measurable performance target
• defined performance horizons
• quantified confidence levels for achieving the target