Ch 16: Asset-liability management Flashcards
What are the two key principles of investment?
- A provider should select investments that are appropriate to the nature, term, currency and uncertainty of the liabilities and the provider’s appetite for risk.
- Subject to the first constrain, the investments should be selected to maximize the overall return on the assets, where overall return includes both income and capital gains.
List the features that might be covered when asking to describe a cashflow
- Direction (positive or negative)
- Size
- Nature
- Term and timing
- Currency
- Certainty (of both timing and amount)
Describe the cashflows on a single life immediate annuity from the perspective of the provider
Single premium - an initial lump sum positive cashflow
Annuity payments - a regular series of negative amounts. The timing of these cashflows are usually known. The amount will usually be known either in monetary or real terms. The total term of payment is unknown as it will depend on how long the annuitant lives.
Investment - an initial negative cashflow, then a series of positive cashflows in the form of interest and capital payments from the bonds in which the provider has invested.
Expenses - an initial lump sum negative cashflow to cover commission and set up expenses. This is followed by a regular stream of negative cashflows to cover the administration of paying benefits. These can be expected to increase over time in line with a mixture of price / wage inflation.
Describe the cashflows on a term assurance from the perspective of the provider
Premiums - a regular series of positive payments. The timing is usually known. The amount is usually known and fixed. The total term of premium payment is unknown as it will depend on when/if the policyholder dies. A variation is a single premium contract.
Benefit - a lump sum negative cashflow paid on the death of the policyholder. The timing is unknown. The amount of the sum assured is known. If the policyholder survives then there will be no benefit cashflow.
Investment - a series of positive cashflows in the form of income and gains from the investments in which the provider has invested ( and negative cashflows when the investments are initially purchased)
Expenses - an initial lump sum negative cashflow to cover commission and set-up expenses. A termination lump sum negative cashflow is payable on death to cover claims handling expenses. There will also be regular negative cashflows to cover administration expenses.
Describe how the cashflows from the perspective of the provider on a (without-profit) endowment assurance differ from those on a term assurance
There will be an additional lump sum negative cashflow on the maturity date of the contract if the policyholder survives until the end. The amount will be known.
There may be a lump sum negative cashflow if the policyholder surrenders the contract before the end of the contract term. The amount may be known or unknown, depending on the terms of the contract.
For a given sum assured, the premiums will be greater than for a term assurance policy.
Investment income and gains will also be greater.
Describe the cashflows on a repayment loan from the perspective of the provider
Loan amount - an initial lump sum negative cashflow equal to the loan amount
Interest and capital payments - a regular series of positive payments. Each payment comprises part interest, part capital. The capital (interest) component increases (decreases) over the period of the loan. The total amount may be fixed, variable, or specified to increase / decrease over the period of the loan. The timing and the total term of payments is usually known, unless the loan is repaid early or the borrower defaults.
Expenses - an initial lump sum negative cashflow to cover commission and set - up expenses. This is followed by a regular stream of negative cashflows to cover the administration of collecting premiums. These can be expected to increase over time in line with a mixture of price / wage inflation.
Describe how the cashflows on an interest only loan differ from those on a repayment loan from the perspective of the provider
For an interest only loan the regular payments received by the provider comprise only interest, not interest and capital. The amount may be fixed or variable.
There will be an additional lump sum positive cashflow: the capital repayment. The amount is usally known and equal to the initial loan amount. The timing is usually known unless the borrower dies, repays the loan early or defaults.
Describe the cashflows on a motor insurance contract from the perspective of the provider
Premiums - a lump sum positive cashflow paid at the start of the year or a regular series of positive monthly cashflows paid throughout the year. The amount and timing if the cashflows are usually known unless endorsements are made to the policy throughout the year or the policyholder dies.
Claims - negative cashflows to cover the costs of claims. There may be more than one claim payment in respect of the period of cover and there may be reporting and settlement delays. The timing and amount of the cashflows are unknown.
Investment - a series of positive cashflows in the form of income and gains from the investments in which the provider has invested ( and negative cashflows when the investments are initially purchased)
Expenses - an initial lump sum negative cashflow to cover commission and set up expenses. Negative cashflows incurred between claim reporting and settlement to cover claim expenses.
Define the ‘net liability OUTGO’ for a provider
Benefits (or claims)
+ expenses
- contributions (or premium) income
Four types of liabilities by nature
- Guaranteed in money terms
- Guaranteed in terms of an index
- Discretionary
- Investment - linked
Suggest a good asset match for liabilities guaranteed in money terms
Conventional bonds of an appropriate term.
However, an exact/pure match is normally impossible since the timing of the asset proceeds is unlikely to coincide exactly with the liability outgo. Additionally, the available bonds may not be long enough in duration.
The bonds should be of high quality given that the benefit is guaranteed.
Derivatives could be used, but are generally considered expensive and exact matching may not always be possible.
Suggest a good asset match for liabilities guaranteed in terms of an index
Index linked bonds of an appropriate term.
However, these may not be available or they may not be linked to exactly the same index as the liabilities.
Alternatively, equities or property may provide a broad match.
Suggest a good match for discretionary liabilities
Assets expected to yield a high, real return, e.g. equities or property
However, the choice will also be affected by policyholders’ expectations and the provider’s appetite for risk.
List 4 reasons why it is not normally possible to achieve pure matching
- The timing or amount of asset proceeds or net liability outgo may be uncertain, e.g. due to options, discretionary benefits
- Pure matching would involve buying excessive amounts of certain securities, which is likely to be prohibitive.
- Pure matching would generally require risk-free zero-coupon bonds or strips with exactly the same term as the liabilities, which do not usually exist, or are too expensive.
- Some liabilities are of such a long term that suitably long-dated assets do not exist
Suggest a good asset match for investment linked liabilities
The provider can avoid any investment mismatching problems by investing in the same assets as used to determine the benefits.
If this requires replicating a market index then it may involve holding a large number of small holdings and thus be too costly. Companies might choose to use CISs that track the investment or a derivative strategy to do this.
