Panning

Question 1

Objective of asset-liability management (ALM)

Answer 1

to measure and manage the degree to which the economic value of an insurer is adversely exposed to changes in interest rates.

Question 2

Describe franchise value

Answer 2

The economic value to the firm of future renewals.
ALM fails to consider the existence of franchise value.
For example, the expected profit for a directly marketed policy may be negative, but the firm obtains a customer who is highly likely to renew the policy. Future profits from subsequent renewals should more the offset the losses incurred in the short-term by selling the policy.
Since franchise value is tied to prospective renewals, it consists of the present value of expected future cash flows from renewal business. Thus, it’s exposed to interest rate risk.

Question 3

How is that possible that the duration of premium is higher than the duration of expenses, even though premium and expenses are both received and paid at the beginning of the year?

Answer 3

Premium cash flows are interest sensitive.

Question 4

Two impacts of an increase in interest rate

Answer 4

1. The present value of future premiums declines
2. The number of dollars of future premium declines (this can be minimized by adopting a different pricing strategy)

Question 5

How to reduce the duration of their invested assets

Answer 5

1. Changing the composition of the firm’s investment portfolio
2. Purchasing derivative securities that modify the firm’s asset portfolio

Question 6

Two problems with reducing total duration through reducing invested assets duration

Answer 6

1. The greater the franchise value, the more difficult it is for the firm to manage the interest rate risk of its total economic value by reducing the duration of its investment portfolio. Firms would have to reduce the duration of their invested assets to zero.
2. The benefits of implementing the duration reduction strategy would be invisible to regulatory bodies and rating agencies. Instead, these entities would only see the accounting figures of the firm which may actually lead them to conclude that the firm is increasing risk rather than reducing it.

Question 7

Describe the pricing strategy to reduce duration

Answer 7

We can optimize the pricing policy by selecting a and b parameters that retain the target return on surplus but also reduce the duration of total economic value.

Question 8

Advantage of using pricing strategies to manage duration

Answer 8

Avoids the potential rating agency and regulatory risk associated with strategies that seek to reduce the duration of the firm’s franchise value by managing the duration of its investment assets. This is because the dynamic pricing policy is invisible to these external audiences.

Question 9

Limitation of using pricing strategy to manage duration

Answer 9

Any desired combination of a target return on surplus AND target duration of total economic value can only be rigidly maintained for a narrow range of interest rates.
Large changes in interest rates will disrupt the combination established.