Chapter 16 - Asset-Liability management

Question 1

What are some of the main considerations when deciding how to match assets and liabilities? (6)

Answer 1

Is matching necessary and to what degree

Regulation

Trade-off between matching and maximising
investment returns

How practical will it be to match assets to liabilities

Optimal matched position

Level of free assets required when deciding not to match.

Question 2

What is the optimal matched position?

Answer 2

Matched position which satisfies the provider’s required degree of certainty in meeting their liabilities for the lowest cost, while accounting for regulation and investment objectives.

Question 3

What are free assets?

Answer 3

Additional capital which is held to cover the possibility that there are insufficient assets to meet the liabilities when they fall due.

Question 4

What are the principles of investment?

Answer 4

1) Should select investments which are appropriate to the:
Nature
Term
Currency
Uncertainty
of the liabilities, as well as the risk appetite of the provider.
2) Subject to this, investments should be selected to maximise the overall return on assets, comprising of income and capital returns.

Question 5

When asked to describe cashflows in an exam, what are the important points to consider?

Answer 5

From who's perspective are you examining the cashflows
What are the main cashflows
Characteristics of the cashflow such as:
Positive or negative (Income or outgo)
Fixed or real
Certain or uncertain amount
Certain or uncertain timing and term
Structure of the cashflow, e.g. lump sum or regular payments

Question 6

Net liability outgo = ? (for an insurer)

Answer 6

Benefit pmts + expense outgo - premium/contribution income

Question 7

What are four different types of liability outgo which have differing degrees of certainty for the provider?

Answer 7

Guaranteed nominal
Guaranteed in terms of an index
Discretionary
Investment-linked

Question 8

Go through pp.10-12 to see considerations when matching assets to the nature of the liabilities.

Answer 8

.

Question 9

Read through pp.13-15 for considerations to be made when using free assets for mismatching purposes, depending on the nature of the liabilities.

Answer 9

.

Question 10

What are the main types of regulatory controls to be expected when using a mismatched asset strategy?

Answer 10

Restrictions on types of assets which can be invested in

Restrictions on the amount of a type of asset which can be used for demonstrating solvency

Restrictions on maximum exposure to a single counterparty

A requirement to match the currency

Requirement to hold a proportion of total assets in a particular class

Requirement to hold a mismatching reserve

Custodianship of assets

Limit to the extent which mismatching is allowed

Question 11

What is pure matching? Mention some practical issues with this type of matching

Answer 11

Structuring the flow of income and maturity proceeds from assets to precisely coincide with the net outgo from the liabilities under all circumstances.

Many pure matching strategies would require risk free zero-coupon bonds.
Relative price of bonds chosen may be inappropriate.
Term and size of liabilities may make matching unattainable due to unavailability of assets.

Question 12

What is liability hedging/approximate matching?

Answer 12

Assets are chosen in such a way as to perform in a similar way to the liabilities.

This involves trying to find the best matched position, given constraints on available assets.

Question 13

What is immunisation, in terms of liability hedging?

Answer 13

Investing assets in such a way the PV of assets - PV of liabilities is robust to a small change in the interest rate (i.e. it will remain positive).

Question 14

What is duration?

Answer 14

Weighted-average time to payments, where the weights are the present values of each payment. (Can see it as first derivative of payments in terms of time * -v/PV of payments) - see p.19

Question 15

What is convexity?

Answer 15

Volatility of cashflows to a change in the interest rate. See p.19 (take note of relationship with duration in the case of an annual coupon bond)

Question 16

What are the limitations of immunisation theory (7)?

Answer 16

Aimed at meeting fixed nominal liabilities, not real liabilities (however can be adapted to index-linked liabilities).

Possibility of mismatching profits is also removed, apart from a small second-order effect.

Holds true for small changes in interest rate, but large changes could still be detrimental.

Theory assumes a flat yield curve and requires the same change in interest rates at all terms, but yield curve will change shape occasionally in reality.

Theory ignores the dealing costs of rearranging assets due to the need to rebalance the discounted mean term of spread of asset proceeds due to uncertain timing of payments.

Assets of suitably long discounted mean term may not exist.

Unknown timing of asset proceeds and liability outgo.