Mismatching

Question 1

Two key influences on providers decision on mismatching

Answer 1

Two key influences on the provider’s decision on mismatching ( appropriate balance
between risk and return ) :
▪ The level of free assets
o provider can depart from matching strategies outlined above to improve
the overall return on its assets
o which benefits clients and shareholders – higher benefits or lower
premiums, high dividends
o assets that have the highest expected return have a high variance(risk)
▪ Regulatory constraints : Regulatory interventions
o Restrict the type of assets the provider can invest in
o Restrictions on the amount on each particular type of asset than can be
taken into account when demonstrating solvency
▪ To encourage and ensure minimum diversification and
▪ limit the use of risky assets
▪ likely to happen with derivatives due to their volatility of value
o A requirement to match assets by currency
o Restrictions on maximum exposure to single counterparty
o Custodianship of assets
▪ Custodian holds assets on behalf of investor and able to account
independently of any financial transaction
▪ Services : income collection, tax recovery, cash management,
securities settlement , foreign exchange and stock lending
o Requirement to hold certain proportion of assets in a certain asset class
o Requirement to hold mismatching reserve
o Limit on extent in which mismatching is allowed

Question 2

Guaranteed benefits

Answer 2

When there is mismatching, the probability of that assets will be inadequate to meet
liabilities is high
- Having free assets can make up for all of this , or else this would lead to insolvency
- Deterministic approaches can be used to determine the level of free assets required
- Need to consider where the free assets will be invested as this will also be affected by
market value changes
- Calculation of these reserves :
o Assets are selected to match the value of liabilities exactly
o Introduce specified changes in the value of these assets and in economic factors
such as interest rates are assumed – the value of assets and liabilities are calculated
▪ Assumptions are made about how key economic factors will change in the
future and impact on assets values
▪ Need to also assess the value of liabilities
o The difference between the value of assets and the value of liabilities is then the
provision required or the amount of free reserves needed to be set aside
o Opportunities of departing from matched strategy are limited by costs of capital

Question 3

Discretionary benefits

Answer 3

• There is normally a minimum guaranteed value that policyholders will get and they may
  have expectations as to the bonus in with profit business or pension increases in benefit
  schemes
• The provider may want to make use of some free assets or a limited matching strategy
• This is done to ensure that the probability of the discretionary benefits falling below a
  particular level stays within acceptable limits

Question 4

Investment-linked

Answer 4

• The provider may use free assets to mismatch investment linked benefits if by doing so the
  company can expect to achieve a higher return ( high risk strategy )
• Any return achieved above that on the matched assets will not accrue to the beneficiaries of
  the investment-linked contracts but to the provider
• However , for many institutions , matching considerations outweigh return considerations ,
  particularly for risk averse providers
• Therefore it is uncommon to mismatch investment-linked benefits and in some territories , it
  may be disallowed by regulation or law

Question 5

Banking sector

Answer 5

• Banks also mismatch their liabilities and assets
• They normally borrow short and lend long – money they loan out to customers will
  normally have longer term than the deposits they take In : This creates liquidity risk