Chapter 20: Actuarial Techniques (2) Flashcards
Outline what is meant by liability hedging
Explain why cashflow matching using government bonds can lead to difficulties
Choosing assets so that total values of assets and liabilities is same under all circumstances
Problems when cashflow matching using government bonds include:
The assets may not fully cover the liabilities
The term of the liabilities may extend longer than the term of available bonds
There may be gaps between the maturities of available bonds
there may be credit risk with government bonds
there is a risk of a change in tax status of government bonds
there may be a “mark to market” risk between the valuation of assets and valuation of liabilities
Describe the advantages of using swaps to improve cashflow matching
Using RPI swaps, the approach can be extended to match inflation linked liabilities
Swap duration can be longer than the duration of available bonds
swaps can be more liquid than bonds
the costs of a swap can be less than that of a bond portfolio
full duration hedging can be achieved even if the scheme is underfunded
swaps are flexible, particular with respect to exact term of swap
Describe the disadvantages and drawbacks of using swaps for cashflow matching
SDA agreement can be expensive and time consuming
swaps may require collaterisation
closing out a swap can be harder than selling a bond
counterparty risk exists with the banking counterparities
institutions usually pay floating (and recieve fixed) which means that the assets have to earn LIBOR - this is not always easy
Basis risk exists between the swap yield curve and bond yield curve
Explain the term “liability driven investment
LDI is not a strategy or a type of product available in the market but an approach to setting investment strategy, where the asset allocation is determined in whole or in part to a specific set of liabilities
Under an LDI approach it is possible to closely match:
the interest rate sensitivity (duration) of the liabilities
the inflation linkage of the liabilities
the shape of the liabilities
Describe the different approaches to LDI that different investors may have
Some investors will focus on matching cashflows, whereas other will focus more on balance sheet hedging ie aligning asset and liability sensitivity under changes in interest rates and inflation expectations
The latter approach is likely to result in an investor accepting a degree of cashflow mis-matching in return for lower basis risk
Explain how a LDI strategy would be implemented and any risks that may remain
Implementing an LDI strategy an investor would expect change in the value of their assets of closely match changes in the value placed on the liabilities
A combination of interest rate and inflation bearing assets cab provide a close match of projected benefit cashflows, effectively immunising an investor against future changes in interest rates and inflation
There are many different approaches to managing LDI, although most investors tend to focus on swap portfolios or long duration bond management. It is also possible to use repos to replace swaps in this process
Non investment risks such as longevity tend to remain
Give examples of measures used by institutions to combat these other risks
Measures include
Interest rates or inflation hedging
Longevity swaps
Longevity insurance policies - Exchange fixed payments ‘premiums’ or expected payments to annuities) in return for floating payments (‘claims’ or actual payments to annuitants)
Explain the relevance of dynamic liability benchmarks
Dynamic liability benchmarks
Benchmarks that vary with changing nature of liabilities
intermediate position between conventional ‘static’ benchmarks and full liability hedging
important in relation to currencies, where nature of liability portfolio can change very rapidly as market conditions change
may lead to desire to hold higher proportion of liquid assets, so as to be able to respond to changing circumstances
