Chapter 17- Asset Liability Management

Question 1

outline that nature of life insurance business? (4)

Answer 1

• Life insurance companies are liability driven business whose core is to create and underwrite insurance policies
• And invest policy premiums in the financial markets to generate cashflows to fund contractual obligations and generate acceptable returns for shareholders
• A life insurance company is also a risk and capital management business that manages insurance risk that arise from writing insurance policies and financial market risk from investing premium and holding solvency capital
• One of the risk controls used by insurance firms is asset liability management

Question 2

Define asset liability management? (2)

Answer 2

• ALM is the practice of managing business such that decisions and actions taken with respect to assets and liabilities are coordinated
• ALM can defined as formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve financial objectives within risk tolerances and constraints

Question 3

Define asset liability matching?(4)

Answer 3

• Asset liability matching is a fundamental component of the broader ALM process that entails ensuring adequate alignment between insurer’s assets and liabilities and that any mismatch between characteristics are quantified to ensure they are within the risk appetite of the insurer
• Asset liability matching is used as a tool to ensure that enough money is available to meet liabilities (solvency) and cashflows are of such a nature that they are available when need (liquidity)
• The extent of diversion depends on the extent of mismatch risk the company is willing to take with respect to the liabilities
• Asset liability matching not only requires that there is enough money in total liabilities but the cashflows are satisfactory such that money is available at the right time

Question 4

Define asset liability modelling? (1)

Answer 4

• Asset liability modelling is analytical tool to investigate joint behaviour of asset and liabilities over time using consistent scenarios and alternative strategic options (investment strategies)

Question 5

outline the influences on an insurers risk appetite? (2)

Answer 5

• The surplus capital of the insurer (cushion to absorb loss from adverse experience)
• Intrinsic asset/liability mismatch tolerance

Question 6

Outline the components of risk budgeting? (2)

Answer 6

• The level of risk that should be established

* Where it is most efficient to take that risk

Question 7

Outline a standardised steps that will be followed in a asset liability matching exercise? (9)

Answer 7

• Step 1 clarify key objectives from the process or desired outcomes from the ALM exercise
o Future on-going funding levels
o Future solvency levels (SCR cover ratio)
o Investment guarantee reserves
o Economic capital

• Step 2 determine suitable assumptions for parameters and distribution functions (if relevant)
o Establish a cashflow model to value assets and liabilities
o Decide which parameters to model stochastically and which to model deterministically
o Decide on dynamic links between variables (e.g. bonus rates and investment conditions)
o Decide whether to include new business
o Set the projection time frame and the frequency for projection
o Set clear and measureable criteria for the outcomes such as free surplus covers the required capital with 99.5% confidence over the period of horizon

• Step 3 Collect and validate data to be used in the modelling and possibly use it to set model points
• Step 4 Run the model storing outputs generated by the model
• Step 5 consider the overall nature of liabilities
• Step 6 analyse how results may be influenced by a different investment strategy
• Step 7 Assess the interaction between risk and reward and find a point where risk is minimised and reward is maximised based on risk appetite
• Step 8 do sensitivity testing and scenario testing
• Step 9 summarise and present the results to make a decision e.g. investment strategy

Question 8

outline possible scenarios that can be considered in projections? (5)

Answer 8

 Hyperinflation (eg Zimbabwe)

 Disinflation (eg Japan)

 Prolonged collapse in equity markets (eg 1970s SA)

 Sharp fall in equity & property (eg credit crunch)

 Continuation of healthy investment conditions

Question 9

Outline the considerations in an investment model? (5)

Answer 9

• Care needs to be taken to avoid model risk which arises due to inadequate modelling of tails or extreme values
• It is important to understand which assumptions are critical to the outcomes of the model
• Allowance of interaction between model variables needs to be consistent with reality
• The frequency to projection steps will also need to be considered as this influences the accuracy and computational power of the model
• The business strategies such as assets allocation and bonus distributions needs to be considered

Question 10

outline the factors that influecne an investment strategy for a with-profit business? (4)

Answer 10

• Matching of with profit business is difficult due to the discretionary element of benefits
• There is a trade-off between policyholder bonus expectations and the safest investment strategy
• The bonus philosophy with respect to the split between regular and terminal bonuses and vested and non-vested bonuses will impact the matching requirements
• Derivative instruments are increasing being used as assets to achieve a balance in the investment strategy

Question 11

outline the factors that influecne an investment strategy for a without-profit business? (2)

Answer 11

• Without profit business such as annuity portfolios contain significant investment guarantees therefore the degree of matching influences inherit risk to the business
• Bonds and interest rate swaps are examples of appropriate assets for matching without profit contracts

Question 12

outline the factors that influecne an investment strategy for a index-linked business? (2)

Answer 12

• Matching Assets are usually index-linked bonds and a portfolio of underlying assets that mirror the index
• If the investment do not exactly mirror the index then there is a risk of tracking error arising which could lead to losses

Question 13

Outline various reasons why reasons why derivatives may be used in an investment strategy? (5)

Answer 13

• Increase available capital or profit
• Reduce tax or investment cost
• Effective and efficiently acquire or dispose positions in assets
• Hedge aspects of guarantees in with-profit contracts
• Provide exposure to match investment guarantees