Chapter16-Asset-liability management

Question 1

Framework

Answer 1

1 Two key principles of investment
2 Features in describing cash flows
3 Immediate annuities cash flows
4 Term assurance cash flows
5 Endowment vs term assurance cash flows
6 Repayment loan cash flows
7 Interest-only loan vs repayment loan
8 Motor insurance contract cash flows
9 Net liability outgo for a provider formula
10 Liability types
11 Expenses and premiums/contributions as a type of liability
12 Asset matches for liabilities guaranteed in monetary terms
13 Asset matches for liabilities guaranteed in terms of an index
14 Asset matches for discretionary liabilities
15 Asset matches for investment-linked liabilities
16 Impact of free assets on investments strategy of an insurance company
17 Determining mismatching reserve
18 Limitations on investment imposed by the regulator (TECH SCAM)
19 Pure matching
20 Reasons why pure matching is not normally possible
21 Liability hedging
22 Unit-linked liability hedging
23 Asset-liability model
24 Monitoring the success of the output of an asset liability model
* Definition of immunisation
** Conditions for immunisation
*** Limitations of immunisation

Question 2

Limitations on investment imposed by the regulator

Answer 2

Types of assets that a provider can invest in

Exposure to a single counterparty may be limited

Currency matching requirement

Hold certain assets, eg government bonds

Mismatching allowance

Custodianship of assets

Amount of any one asset used to demonstrate solvency may be restricted

Mismatching reserve

Question 3

Definition of immunisation

Answer 3

Investment of assets in such a way that the present value of the assets less the present value of the liabilities is immune to a general small change in the rate of interest.

Ensuring that the present value of assets is no less than that of the liabilities.

Question 4

Conditions for immunisation

Answer 4

VA = VL
PV of liability-outgo = PV of asset-proceeds

∑tv^tA(t) / ∑v^tA(t) = ∑tv^tL(t) / ∑v^tL(t)
DMT of asset-proceeds = DMT of liability-outgo

∑t^2v^tA(t) / ∑v^tA(t) > ∑t^2v^tL(t) / ∑v^tL(t) Spread (Convexity) about DMT of asset-proceeds > spread
about DMT of liability-outgo

L(t) is the expected net outgo of the existing business

A(t) is the expected proceeds from the existing assets in year t

VL is the present value of the liability-outgo at the ruling rate of interest

VA is the present value of the asset-proceeds at the same rate of interest

Question 5

Limitations of immunisation

Answer 5

Aimed at meeting fixed monetary liabilities (theory can be applied to index-linked liabilities by using index-linked bonds)

By immunising, we remove possibility of mismatching profits/losses apart from a small second-order effect

Theory relies upon small changes in interest rates. Fund may not be protected against large changes in interest rates.

Theory assumes a flat yield curve and requires the same interest rates at all terms.

In practice, the portfolio must be rearranged constantly to maintain the correct balance of:

• Equal discounted mean term
• Greater spread of asset proceeds

Theory ignores dealing costs of a daily (monthly) rearrangement of assets

Assets of suitably long discounted mean term may not exist.

Timing of asset proceeds and liability outgo may not be known.

Question 6

Pure matching

Answer 6

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

Question 7

Liability hedging

Answer 7

Liability hedging is where the assets are chosen in such a way as to perform in the same way as the liabilities. Liability hedging aims to select assets that perform exactly like the liabilities in all states.

This is usually not achievable in practice. Instead, the investor might try to hedge liabilities with respect to specific factors.

Examples of this include currency matching and hedging unit-linked liabilities.