Panning

Question 1

asset liability management measures

Answer 1

the impact of changing interest rates on the economic value of firm

Question 2

Asset Liability analysis conducted by most firms does not account

Answer 2

franchise value

Question 3

franchise value

Answer 3

represents the economic value of the profits that will be earned in the future years from the future renewals of the current policies

-franchise value can make up large portion of total economic value

Question 4

franchise value: where it is reflected and risk

Answer 4

• The value is reflected in the firm’s stock price
• It is based on the PV of future cash flows to the firm, and is therefore exposed to interest rate risk
• It is usually invisible to senior executives, and is therefore unmanaged

Question 5

duration of premium

Answer 5

• duration of premium exceeds duration of expenses and losses even though premium is paid at the same time as expenses and a year before losses
• property is due to assumption that premium is sensitive to interest rates: when interest rates increase, premium size falls

Question 6

The franchise value presents the firm with a practical dilemma that has 2 components

Answer 6

• The greater the franchise value of the firm, the more difficult it is to manage the interest rate risk
• The firm could reduce the duration of invested assets to try offset the franchise value to the duration. However, this may puzzle regulatory authorities/ rating agencies, as they only see the accounting numbers

Question 7

Regulators and rating agencies only look at accounting numbers so

Answer 7

franchise value is invisible to them

They may mistakenly see the firm’s actions of reduce the duration of invested assets as increasing risk rather than reducing it, or worse, as jeopardizing the firm’s solvency & financial rating

Question 8

An alternative strategy

Answer 8

adopt a pricing strategy that reduces the sensitivity of the franchise value to interest rates

One such strategy is to alter the values of a & b, this will result in a drop in duration and then the duration of total economic value drops

Set ROS=a+by where b≠0 (ROS varies with interest rate)

Question 9

use of pricing strategy avoids

Answer 9

rating agency & regulatory risk

Question 10

ideal method to manage duration

Answer 10

is to find the right parameters a and b such that the return on surplus and duration are both acceptable

Question 11

advantages and disadvantages of pricing strategy

Answer 11

Advantages include: -Avoids rating agency and regulatory risk that are associated with managing the duration of the invested assets

The disadvantages include: -The desired combination of target return on surplus and target duration can be maintained only for small interest rate changes