Chapter 16: Asset-liability management Flashcards
(26 cards)
What is meant by the optimal matched position?
The optimal matched position will be the matched position that satisfies the provider’s regulatory requirements and other investment objectives.
If the decision is taken to match the assets to the liabilities, then the optimal matched position will need to be determined.
If the decision is taken not to match the assets to the liabilities, then additional capital will need to be held to cover the possibility that there are insufficient assets to meet the liabilities when they fall due.
What are the 2 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 constraint, the investments should also be selected so as to maximise the overall return on the assets, where overall return includes both income and capital.
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 cashflow 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 usually 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 of 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.
Compare the cashflows on a standalone critical illness contract with those on a term assurance contract with a critical illness rider from the viewpoint of the policyholder
Premium - Both contracts will have a single or regular negative cashflow, the premium. These amounts will be known and payable for the term of the contract or until the benefit event or death if earlier.
Benefit - Both contracts will have the size depend on the investment type of the contract, the timing is unknown.
Under a standalone CI contract there will be a single positive cashflow, the benefit payment on diagnosis of a critical illness covered by the policy during the contract term. On maturity or death no cashflows occur.
Under CI rider term assurance there will be a positive cashflow on diagnosis of CI or death during the contract term. If the policyholder suffers both CI and death, the 2 benefit payments are made. No benefit at maturity is paid.
Surrender payment - CI and term assurances do not normally pay a benefit on surrender. However, depending on the terms of the contract, it may be a single positive cashflow if the policyholder withdraws from the contract before the end of the term. The timing and size of this cashflow are unknown at outset.
Define the ‘net liability outgo’ for a provider
Benefit payments (or claims)
+ expense outgo
- premium / contribution income
In practice, the actual liability outgo in any year, or month, depends on:
- the monetary value of each of the constituents, and
- the probability of it being received or paid out.
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 be affected by policyholders’ expectations and the provider’s appetite for risk.
Suggest a good 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.
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.
Explain how the existence of free assets affects the investment strategy of an insurance company
The existence of free assets or a surplus means that the provider can depart from the matching strategies outlined above to improve the overall return on its assets and thereby benefit its clients and shareholders.
If the assets supporting guaranteed benefits are invested to produce the highest expected return without any thought to the nature of the liabilities, the probability that the asset proceeds will be inadequate to meet the liabilities will be high. If there are free assets they can be used to make up the shortfall in these circumstances.
Using free assets to maintain a deliberately mismatched policy has to compete with other uses of free assets, in particular financing new business growth or other new ventures.
The provider of discretionary benefits can make use of the free assets / surplus to ensure that the probability of the discretionary benefits falling below a particular level stays within acceptable limits, while investing for maximum returns.
It could be reasonable to use free assets / surplus to mismatch investment-linked benefits if by doing so the company can expect to achieve a higher return.
Give 8 examples of how the regulatory framework might limit what a provider wants to do in terms of investment
- Restrictions on the types of assets that a provider can invest in
- Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
- A requirement to match assets and liabilities by currency
- Restrictions on the maximum exposure to a single counterparty
- Custodianship of assets
- A requirement to hold a certain proportion of total assets in a particular class
- A requirement to hold a mismatching reserve
- A limit on the extent to which mismatching is allowed at all.
Define “pure matching”
In its purest form, matching of assets and liabilities involves structuring the flow of income and maturity proceeds from the assets so that they coincide precisely with the net outgo from the liabilities under all circumstances.
Define “liability hedging”
Liability hedging is where the assets are chosen in such a way as to perform in a similar way to the liabilities.
Immunisation
Immunisation is the investment of the assets in such a way that the present value of the assets less the present value of the liabilities is immune to a general small change in interest rate.
The conditions for immunisation are:
1. The present value of the liability-outgo and asset-proceeds are equal
2. The discounted mean term of the value of the asset-proceeds must equal the discounted mean term of the value fo the liability-outgo
3. The spread (convexity) about the discounted mean term of the value of the asset-proceeds should be greater than the spread of the value of the liability-outgo.
List 7 theoretical and practical problems with immunisation
- Immunisation is generally aimed at meeting fixed monetary liabilities. Many investors need to match real liabilities. However, the theory can be applied to index-linked liabilities by using index-linked bonds.
- By immunising, the possiblity of mismatching profits as well as losses is removed apart from a small second-order effect.
- The theory relies upon small changes in interest rates. The fund may not be protected against large changes.
- The theory assumes a flat yield curve and requires the same change in interest rates at all terms. In practice the yield curve does change shape from time to time.
- In practice the portfolio must be rearranged constantly to maintain the correct balance of equal discounted mean term and greater spread of asset proceeds. The theory ignores the dealing costs of a daily (or even monthly) rearrangement of assets.
- Assets of a suitably long discounted mean term may not exist.
- The timing of asset proceeds and liability outgo may not be known.
What is an ‘asset-liability model’
An asset-liability model is a tool to help determine what assets to invest in given a particular objective or objectives.
In setting an investment strategy to control the risk of failing to meet the objectives, a method that considers the variation in the assets simultaneously with the variation in the liabilities is required. This can be done by constructing a model to project the asset proceeds and liability outgo into the future.
