Chapter 16: Asset liability management

Question 1

What features of liabilities should be considered when deciding in which assets to invest

Answer 1

1. Nature of liabilities
2. Term of liabilities
3. Currency of liabilities
4. Uncertainty of liabilities

Question 2

What are net liabilities?

Answer 2

Net liabilities = Benefit payments + Expense outgo - Premium income

Question 3

What is the difference between pure and approximate matching?

Answer 3

Pure matching matches in terms of timing and amount of liabilities

Approximate matching

Question 4

How can liabilities be categorised?

Answer 4

• Guaranteed in money terms
• Guaranteed in terms of an index
• Discretionary
• Investment-linked

Question 5

How can expenses be categorised?

Answer 5

Increase overtime somewhere between price and earnings inflation

Question 6

How can premiums be categorised?

Answer 6

• FIxed in monetary terms

- Increase in line with an index

Question 7

What would the matching asset portfolio look like for each of the four categories of liabilities

1. Guaranteed in money terms
2. Guaranteed in terms of an index
3. Discretionary
4. Investment-linked

Answer 7

Guaranteed in money terms

• Choose assets that make payments at an appropriate level and time as liabilities fall due
• Government and conventional bonds
• Swaps

Guaranteed in terms of an index

• Index-linked government and corporate bonds of the appropriate term
• Equity and property over the longer term

Discretionary

• Equities
• Property
• As they give the highest long-term return

Investment-linked

• Replicating portfolio of assets that track the guaranteed index
• Collective investment scheme
• Derivatives

Question 8

What influences the level of mismatching allowed

Answer 8

• Risk appetite
• Free assets
• Regulatory constraints
• Type of policy - guaranteed or discretionary benefits. The more guaranteed the less scope for taking a risk

Question 9

What is the use of free assets

Answer 9

1. Depart from matched investment strategy to increase returns
2. Fund new business

Question 10

How does the regulator influence risk appetite

Answer 10

Assets

• Prescribed amounts to invest in certain assets, e.g., government bonds
• Restrict the type of assets that can be held
• Restrict amounts in specific assets that can be held

Mismatching

• Limit on level of mismatching allowed
• Allow mismatching but insist on extra reserves to be held for the deviation from the matched position
• Compulsory matching by currency

Risk

• Restrictions on custody of assets, e.g., all assets held domestically so if they invest in gold it has to be shipped to the country and stored domestically
• Restrictions on maximum exposure to a single counterparty

Question 11

What is risk budgeting

Answer 11

Process of establishing how much risk should be taken and where it is most efficient to take the risk in order to maximise returns

Question 12

Describe the three main components of a risk budget

Answer 12

Strategic risk - Risk of poor performance of strategic benchmark relative to liabilities

Active risk - Risk of poor performance from fund manager relative to a benchmark

Structural risk - Mismatch of aggregate portfolio benchmark and total fund benchmark