Chapter 16: Asset-liability management Flashcards
(26 cards)
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 be selected to maximise the overall return on the assets, where overall return includes both income and capital gains.
What is meant by the optimal match position?
The optimal matched position will be the matched position that satisfies the provider’s required degree of certainty in meeting the liabilities for the least cost, taking into account regulatory requirements and other investment objectives.
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 paymetns 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 paymetns 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.
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 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.
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.
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 beneftis
- 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, through higher benefits or lower premium / contribution rates
* shareholders, through higher dividends
Free assets can also be used to make up the shortfall when the assets supporting guaranteed benefits are invested to produce the highest expected return without any thought to the nature of the liabilities. It such a case the probability that the asset proceeds will be inadequate to meet the liabilities will be high.
The provider can make use of free assets / surplus to ensure that the probability of the discretionary benefits falling below a particular level stays within acceptable limits.
It could also be argued that it is a reasonable use of free assets / surplus to mismatch investment-linked benefits if by doing so the company can expect to achieve a higher return. This is a high-risk strategy and may be disallowed by regulation.
Outline 2 methods by which a mismatching / resilience reserve might be determined
- Assets are selected to match the value of the liabilities exactly
- Specified “time zero” changes in the value of these assets and in economic factors such as interest rates are assumed, and the value of assets and liabilities recalculated. The difference (if the value of the assets is less than the value of the liabilities) is the provision required, or the amount of free reserves needed to be set aside.
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 liablities 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, for example, government stock
- A requirement to hold a mismatching reserve
- A limit to the extent to which mismatching is allowed at all.
Define the term “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.
This requires the sensitivity of the timing and amount of both the asset proceeds and the net liability outgo to be known with certainty and to be identical with respect to all factors.
Define the term “liability hedging”
Pure liability matching involves choosing assets that provide cashflows that coincide with the liability outgo exactly, whereas liability hedging is where the assets are chosen in such a way as to perform in a similar way to the liabilities.
In other words, hedging against all of the unpredictable changes in the liabilities that arise from unpredictable changs in the factors that influence liability values.
What is 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 the rate of interest.
The purpose of immunisation is the same as that of matching, and immunisation might be used in circumstances when pure matching is not possible.
The classical theory, due to Redington, depends on a considerable simplification of the practical problem; it is assumed that, at a given moment in time, securities can be obtained to yield a uniform rate of interest whatever the term. Furthermore, all the funds are invested in fixed-interest securities, which are either irredeemable or redeemable at a fixed date.
The conditions can be expressed in words as:
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 of the liability-outgo
3. The spread (or equivalently, 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.
What are the theoretical and practical limitations of classical immunisation theory?
- Immunisation is generally aimed at meeting fixed monetary liablities. 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 possibility 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 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.
An investor’s objectives will normally be stated with reference to both assets and liabilities. 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.
