SP20: Actuarial Techniqu (2)

Question 1

Outline what is meant by liabilitiy hedging

Explain why cashflow matching using government bonds can lead o difficulties

Answer 1

Choosing assets o that total values of assets and libilities 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 termof available bonds
• There may be gaps between the maturities of available bonds
• there may be credit6 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 valuton of assets and valuation of liabilities

Question 2

Describe the advantages of using swaps to improve cashflow matching

Answer 2

• Using RPI swaps, the approach can be extended to match inflation linked liabilities
• Swap durations 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

Question 3

Describe the dsisadvantages and drawbacks of using swaps for cashflow matching

Answer 3

• ISDA agreemebnt 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
• instituions usually pay floating (and recieve fixed) which means that the assets have to earn LIBOR - this is not always 3easy
• Basis risk exists between the swap yield curve and bond yield curve

Question 4

Explain the term “liability driven investment

Answer 4

KDU us bit 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 itis possible to closely match:

• the interest rate sensitivity (duration) of the liabilities
• the inflation linkage of the liabilities
• the shape of the liabilities

Question 5

Describe the different approaches to LDI that different investors may have

Answer 5

Some investors will focus on matching cashflows, whereas other will focus more on balance sheet hedging ie alighing asset and liabilitiy 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

Question 6

Explain how a LDI strategy would be implemented and any risks that may remain

Answer 6

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 iinflation bearing assets cab provide a close match of projected benefit cashflows, effectively immunising an investor against future changes in intereest rates and inflation

There are many different approaches to managing LDI, althought most investors tend to focus on swap portfolios or long durations bond management. It is also possible to use repos to replace swaps in this process

Non investment risks such as longevity tend to remain

Question 7

Give examples of measures used by institutions to compbat these other risks

Answer 7

Meaures 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)

Question 8

Explain the relevance of dynamic liability benchmarks

Answer 8

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 porportion of liquid assets, so as to be able to respond to changing circumstances