Chapter 16: Asset-liability management Flashcards
What are the principles of investment?
The principles of investments state that:
Investments should be chosen that are appropriate for liabilities (nature, term, currency and uncertainty) and reflect risk appetite of investor
Investments should be chosen to maximise returns
Principles of investment
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
Subject to the above, investments should be selected so as to maximise the overall return on assets, where overall return includes both income and capital
What is the key decision providers of financial benefits will need to make about the interaction between assets and liabilities?
Interaction between assets and liabilities
Providers of financial benefits will invest contributions received for those benefits in order to deliver benefits
Key decision: whether to invest so that expected cashflows from assets held match those from liabilities and degree to which such matching should be applied
Matched strategy ideal to remove risks of assets performing poorly relative to liabilities
Matching may be required by regulator
Decision to match must be considered taking into consideration need to maximize investment returns – these objectives might conflict
Matched strategy expected to result in lower returns than unmatched strategy
Matching may also not be practical or possible – depending on available assets
If decision taken to match, then optimal matched position will need to be determined
Given uncertainties in future cashflows of different liabilities and possible uncertainties associated with some assets – difficult exercise
Optimal matched position – the matched position that satisfies provider’s required degree of certainty in meeting the liabilities for least cost, taking into account regulatory requirements and other investment objectives
If decision taken not to match, then additional capital will need to be held to cover possibility of insufficient assets to meet liabilities when they fall due
Determination of how much extra capital will be needed is not trivial
Additional capital (free assets) provides cushion against adverse market movements
If correctly determined how much extra capital needed – then should be sufficient assets to meet liabilities when they fall due despite fall in market value of the assets (for example)
How are liability cashflows identified?
Liability cashflows – identification
For insurance companies, positive cashflows (premiums) are received before negative cashflows (claims and expenses) arise
These are available for investment and will generate investment income – which is another positive cashflow
Premium paid by policyholder might be used to cover immediate costs associated with setting up the insurance policy and remainder invested
Investment returns will be earned on premium until further expenses or claims payments are paid out
Where there is uncertainty about the amount or timing of cashflows – actuarial technique is to assign probabilities to amount and existence of a cashflow
Probability that payment will take place could be estimated by looking at past results
What are the points that need to be made when looking at cashflow scenarios?
Examples of cashflow scenarios
Have clear understanding of:
from which party’s viewpoint you are examining the cashflows
what the main cashflows are
whether cashflow is:
- positive or negative
- fixed or real
- known or unknown in amount
- known or unknown in timing and term
- the form of payments i.e. lump sum or regular
What is the cashflow scenario for an annuity and how are liabilities matched?
Example 1: An annuity
An annuity provides a series of regular payments in return for a single premium
Conditions under which annuity payments will made will be clearly specified
For an immediate annuity, payments are made as long as annuitant is alive
Often a guaranteed period – e.g. 5 years for which payments will continue to be made or be commuted into lump sum even if annuitant dies
Cashflows for investor will be initially negative (for purchase of annuity) followed by series of smaller regular positive cashflows throughout the annuitant’s lifetime
Annuities cannot normally be discontinued – unlikely to be discontinuance payment
From the perspective of annuity provider – initial positive cashflow followed by unknown number of regular known negative cashflows
If annuity payments are specified to increase in line with index – the amount of regular negative cashflows will be unknown in monetary terms
Cashflows will comprise of annuity instalments and provider’s expenses in administering the contract
Number of future negative cashflows depends on how long annuitant lives
Provider likely to invest the initial positive cashflow in bond market (negative cashflow) and will receive in return number of interest and capital payments (positive) – expected to match outgoings on expenses and annuity payments and leave some surplus cash as profit
Providers may invest in both government and corporate bonds:
Fixed-interest bonds – used to match level annuities and annuities increasing by fixed amounts
Index-linked bonds – used to match index-linked liabilities
Other investments e.g. commercial mortgages and swaps
What is the cashflow scenario for a repayment loan and how are liabilities matched?
Example 2: A repayment loan (or mortgage)
Repayment loan is repayable by series of amounts – each includes partial repayment of loan capital in addition to interest payments
If interest rate is fixed – payments will be of fixed equal amounts, paid at regular known times
Cashflows are like those for an annuity except that the number of cashflows will usually be fixed (rather than related to survival)
May be added complications if interest rate is allowed to vary or if loan can be repaid early
Possible that regular repayments could be specified to increase or decrease with time
Such changes could be smooth or discrete
Breakdown of each payment into interest and capital changes significantly over the period of the loan:
1st repayment will consist almost entirely of interest and will provide very small capital repayment
Final repayment will consist almost entirely of capital and have small interest content
Particularly relevant when interest and capital are taxed differently
Amount of loan outstanding will reduce throughout term of loan
At start of contract entire loan will be outstanding and so interest part of payment is large and capital part small
At end of contract the amount of the loan outstanding will be small and so interest due will also be small
What does the net liability outgo consist of and what does the actual liability outgo depend on?
Liability cashflows – categorisation by nature
Net liability outgo consists of:
benefit payments
+ expense outgo
- Premium/contribution income
In practice, actual liability outgo in any year or month depends on:
- the monetary value of each of constituents, and
- the probability of it being received or paid out
How are the liability cashflows categorised by nature looking at the benefit payment component?
Benefit payments
- Guaranteed in money terms
Consists of benefit payments where amount is specified in money terms
- Guaranteed in terms of an index of prices, earnings or similar
Consists of benefits whose amount is directly linked to an index
Index may not be nationally published one
For example, benefits accruing under benefit scheme may increase in line with pay awards granted by sponsoring company
Many of the cashflows that fit under this category may not be truly guaranteed
- Discretionary
Consists of any payments that are payable at the discretion of the provider
E.g. future bonus payments under with-profit contracts or pension increases in excess of guaranteed amounts
- Investment-linked
Consists of benefits where amount is directly determined by value of investments underlying contracts
E.g. unit-linked fund where liabilities are directly linked to value of underlying investments, or defined contribution pension scheme
How are the liability cashflows categorised by nature looking at the expense outgo component?
Expense outgo
Expense payments tend to increase over time
Natural rate of increase is likely to fall somewhere between price and earnings inflation
There are exceptional items which might be expenditures or cost savings
For investment purposes, it is adequate to treat expenses as being linked to prices or earnings
Hence, they can be included with benefit payments guaranteed in terms of an index of prices or similar
Administrative expenses may be broadly real but rarely guaranteed to move in line with an index
How are the liability cashflows categorised by nature looking at the premium/contribution income component?
Premium/contribution income
- Premium/contribution payments may:
be fixed in monetary terms…
…and hence can be thought of as negative benefit payments guaranteed in money terms; or
Increase in line with an index…
…and hence can be thought of as negative benefit payments guaranteed in terms of an index
- Existence of contracts or transactions where the client can vary amount of premium each year does not invalidate this
Summarise how the liability outgo can be split by nature.
Summary
- We can therefore split the liability outgo (by nature) into four categories:
guaranteed in money terms i.e.
benefit payments specified in money terms
minus premium/contribution income that is fixed in money terms
guaranteed in terms of a prices index or similar i.e.
benefit payments linked to an index
PLUS, expense outgo that is real in nature
MINUS premium/contribution income that is linked to an index
discretionary benefit payments
investment-linked benefit payments
How are assets selected by nature of liabilities, when liabilities are guaranteed in money terms?
Guaranteed in money terms
Pure matching
Provider will want to invest so as to ensure that it can meet guarantees
This means investing in assets which produce a flow of asset proceeds to match the liability outgo
Match needs to be in terms of both the timing and amount of the liability outgo
Will involve taking into account the term of liability outgo and probability of the payments being made to indicate term of corresponding assets
Approximate matching
Except for certain types of liability – probably impossible in practice to find assets with proceeds that exactly match expected liability outgo
Terms of available fixed-interest securities may be much shorter than corresponding liabilities – particularly with very long-term pension liabilities
Even if suitable assets are available their price may prove off-putting due to increased demand
Existence of options in either liabilities or assets also means that full cashflow matching cannot realistically be achieved
Best match achieved by investing in high quality fixed-interest bonds of term suitable to match expected term of liability outgo
Derivatives could be used to produce asset flows that match liability outgo
Generally expensive and exact matching may not always be possible
How are assets selected by nature of liabilities, when liabilities are guaranteed in terms of a price index?
Guaranteed in terms of a prices index or similar
Most suitable match is likely to be index-linked securities (where available) ideally chosen to match expected term of liability outgo
In their absence, substitute would be assets that are expected to provide real return e.g. equity-type investments
How are assets selected by nature of liabilities, when we have discretionary benefits?
Discretionary benefits
Main aim of provider will be to maximise these and hence the investment strategy should thus also aim to do that
This means investing in assets that will produce highest expected return
In theory, this suggest a great deal of investment risk is acceptable
This is subject to provider’s appetite for risk and risk expectations of the client
How are assets selected by nature of liabilities, when we have investment-linked liabilities?
Investment-linked
Benefits guaranteed to extent that their value can be determined at any time in accordance with definite formula based on value of specified fund of assets or index
Investment matching problems can be avoided by investing in same assets as used to determine benefits
Replicating a market index may involve holding large number of small holdings and thus be too costly
Companies might use CISs or derivative strategy to achieve this
Currency
Liabilities denominated in particular currency should be matched by assets in that currency – reduce currency risk
When is matching used and what are the key influences on the provider’s degree of mismatch?
Mismatching
Look at maximising returns (involve degree of mismatching)
Consider two key influences on provider’s decision on balance between risk and return:
- the level of free assets
- any (regulatory) constraints
How do free assets allow for improved overall returns?
How does the level of free assets affect a provider’s decision to mismatch?
- Free assets/surplus
Existence of free assets or surplus means that provider can depart from matching strategies outlined above to improve overall return on its assets and thereby benefit its:
- clients – higher benefits or lower premium/contribution rates
- shareholders (if any) – higher dividends
Almost always the case that assets with highest expected return also have highest variance of that return
How do free assets affect the matching of guaranteed benefits?
Guaranteed benefits
If assets supporting guaranteed benefits are invested to produce highest expected return without though to nature of liabilities – probability that asset proceeds will be inadequate to meet liabilities will be high
If there are free assets – they can be used to make up shortfall in these circumstances
If no free assets or not enough this approach can lead to insolvency
So, where liabilities are fixed in money terms (guaranteed benefits) – variability in asset return can only be tolerated if there are free assets to act as cushion for variability
But then what size of free assets is appropriate given specified variance of return
Deterministic approach can be used to assess appropriate provision to cover mismatching of assets and liabilities:
- Assets are selected to match value of liabilities exactly
- Specified ‘time zero’ changes in value of these assets and economic factors – e.g. interest rates assumed, and value of assets and liabilities recalculated
- Difference (if value of assets is less than value of liabilities) is the provision required or amount of free reserves needed to set aside
Example
Main technique used to determine how much free assets/surplus is needed to reduce probability of insolvency to acceptable level is same as that used to assess risk-based capital requirement against market risk
Involves running stochastic simulation of markets in which funds are invested using economic scenario generator
Each run will choose particular combo of funds for consideration
Capital required to just prevent insolvency at any desired probability can be determined by inspecting the tails of the output from stochastic simulations
Using free assets to maintain deliberately mismatched policy has to compete with other uses of free assets – financing new business growth or other new ventures
Often means that opportunities to depart from matched policy for guaranteed liabilities are limited
When allocating free assets to support mismatched investment policy – NB to take into account that investment in which the free assets are invested will also be affected by market value changes
How do free assets affect the matching of discretionary benefits?
Discretionary benefits
Could be argued that matching is irrelevant where there are discretionary benefits
Since provider will want to invest in securities with highest expected return
But although benefits are fully discretionary, beneficiaries will expect to receive something and moreover will have expectation as to a min level
Provider will want to make use of some of surplus or limited matching strategy – to ensure that probability of discretionary benefits falling below particular level stay within acceptable limits
How do free assets affect the matching of investment-linked benefits?
Investment-linked
Could be argued that it is a reasonable use of free assets/surplus to mismatch investment-linked benefits if company can expect to achieve higher return
If done any return achieved above that on matched assets will not accrue to beneficiaries of investment-linked contracts but to provider
For many institutions matching considerations may outweigh return considerations
In particular, for risk-averse providers who have chosen to offer benefits that are investment linked rather than guaranteed
Uncommon for providers to mismatch investment-linked liabilities
High-risk strategy and in many countries mismatching investment-linked benefits is disallowed by law or regulation
How does the regulatory constraint affect a provider’s decision to mismatch?
- Regulatory framework
- May limit what provider may be able to do in terms of investment
- The following controls may be implemented:
restrictions on types of assets that provider can invest in
restrictions on amount of any type of asset than can be taken into account for purpose of demonstrating solvency
requirement to match assets and liabilities by currency
restriction on max exposure to single counterparty
custodianship of assets
requirement to hold certain proportion of total assets in particular class e.g. government stock
requirement to hold mismatching reserve
limit on extent to which mismatching is allowed at all
What are the forms of investment matching?
- Pure matching
- Liability hedging
- Immunisation
Discuss the pure matching approach to investment matching.
Pure matching
Matching in purest form involves structuring the flow of income and maturity proceeds from assets so that they coincide precisely with net outgo from liabilities under all circumstances
Requires sensitivity of timing and amount of asset proceeds and net liability outgo to be known with certainty and to be identical with respect to all facts
Some liability cashflows may be difficult to match – complete or pure matching rarely possible
Unless risk-free zero-coupon used rarely possible to achieve pure matching
Close approximation to perfect match may be possible for certain life insurance products e.g. guaranteed income bonds
Relative price of bonds chosen for matching may deter all but most dogmatic institutions
Problem: for some funds term and size of liability may be such that complete matching is unattainable because suitable assets aren’t available
Thus, in practice, matching usually means approximate matching
Useful to view complete matching as benchmark position against which to judge investor’s asset allocation
Discuss the liability hedging approach to investment matching.
Liability hedging
Where assets are chosen in such a way as to perform in a similar way to the liabilities
I.e. hedging against or matching all of unpredictable changes in liabilities that arise from unpredictable changes in factors that influence liability values
Approximate liability hedging
In most situations hedging liabilities with respect to all factors that affect liabilities will not be possible
Investor might try to hedge liabilities with respect to specific factors that affect liability values
Familiar forms of hedging – matching by currency and consideration of real or nominal nature of liabilities when determining choice of assets
These examples relate only to specific characteristics of liabilities – liability hedging aims to select assets that perform exactly like liabilities in all events
Full liability hedging
Possible when considering unit-linked liabilities
When choosing assets to hedge unit-linked liabilities – normal approach is to establish portfolio of assets + determine unit price by reference to value of asset portfolio + then use price to value units and hence liabilities
Value of the liabilities is then implied by values of the assets
Discuss the immunisation approach to investment matching.
Immunisation
Investment of assets in such a way that the PV of assets less PV of liabilities is immune to general small change in rate of interest
Basic explanation of immunisation
Purpose is same as that of matching
I.e. to reduce the risk of failing to meet liabilities as they fall due, arising from change in investment conditions
Might be used when pure matching is not possible
For example, when investment income is initially greater than net liability outgo, then liabilities cannot be matched
But they may be immunised
Note that immunisation relates to ensuring that PV of assets is no less than that of liabilities
Rather than matching dates and mounts of individual cashflows
The conditions for immunisation are:
- The PV of the liability-outgo and asset-proceeds are equal
- The discounted mean term of the value of asset-proceeds must equal the discounted mean term of the value of the liability-outgo
- The spread (or convexity) about the discounted mean term of the value of the asset-proceeds should be greater than the spread of the value of liability-outgo
Algebraic explanation of the conditions for immunisation
We are concerned about the impact of changes in interest rate on V(A)-V(L)
From the 1st condition for immunisation we know that 1st expression is zero (V(A)=V(L))
From 2nd condition for immunisation we know that 2nd expression is zero
From 3rd condition for immunisation we know that 3rd expression is positive – because assets have greater spread/convexity by term than liabilities
So, if epsalon is small then all further terms become insignificant
Thus, under the terms for immunisation, the value of assets exceeds the value of liabilities after change in interest rates
What are the limitations of the immunisation theory?
The limitations of classical immunisation theory
Immunisation is aimed at meeting fixed monetary liabilities – many investors need to match real liabilities, but the theory can be applied to index-linked liabilities by using index-linked bonds
- May be problems in practice due to time lag associated with indexation
The possibility of mismatching profits as well as losses is removed apart from small second-order effect
- Rules out investment in assets with high expected but uncertain returns
Theory relies upon small changes in interest rates – fund may not be protected against large changes
Theory assumes flat yield curve and requires the same change in interest rates at all terms – in practice yield curve does changes shape from time to time
In practice portfolio must be rearranged constantly to maintain the correct balance of equal discounted mean term & greater spread of asset proceeds
- This is because formulae for duration and convexity depend upon times to each payment – which are continuously changing
- Note this is not the case with pure matching where asset proceeds emerge as and when required to meet liability outgo
Theory ignores dealing costs of a daily or even monthly rearrangement of assets
Assets of suitably long discounted mean term may not exist
- Problem reduced by existence of zero-coupon bonds
Timing of asset proceeds and liability outgo may not be known
- Formulae implicitly assume that date of all cashflows are known with certainty
How is an asset-liability model used to determine the investment strategy?
Using a model to determine investment strategy
Asset-liability model is tool to help determine what assets to invest in given particular objective
For example, used to address the questions of:
- how fare from perfectly matched investment position an investor is able to move because of its free assets
- how well cashflows from a chosen set of assets match liability cashflows in range of future economic scenarios
Investor’s objectives normally stated with reference to both assets and liabilities
In setting investment strategy to control the risk of failing to meet objectives – method that considers the variation in assets simultaneously with variation in liabilities is required
Done by constructing model to project the asset proceeds and liability outgo into the future
Advantage – encourages investors to formulate explicit objectives
Objectives should include quantifiable and measurable performance target, defined performance horizons and quantified confidence levels for achieving target
Outcome of particular investment strategy is examined with model and compared with investment objectives
Strategy adjusted in light of results obtained and process repeated until optimum strategy reached
Modelling can either be deterministic or stochastic. What do the two methods entail and what are the pros and cons?
Modelling can either be deterministic or stochastic
Deterministic model – parameter values are fixed and result of running model is a single outcome
Need to carry out a number of re-runs of model based on different sets of assumptions to understand how robust the strategy is
Stochastic model – at least on of parameters is assigned a probability distribution
Model is run many times to generate distribution of outcomes
Arguably most appropriate way of allowing for volatility and uncertainty underlying assets and liabilities
Advantage – it encourages investors to formulate explicit objectives
Objectives should include quantifiable and measurable performance target, defined performance horizons and quantified confidence levels for achieving target
For financial institution – objectives might be specified in terms of results of valuation carried out at specified time in future
In practice, likely to be feedback between the model output and setting of objectives
Success of strategy monitored by means of regular valuations
Valuation results compared with projections from modelling process and adjustments made to strategy to control level of risk accepted by strategy (if necessary)
