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Actuarial techniques (2) (Liability-driven investment (LDI) (Under an LDI…
Actuarial techniques (2)
Liability hedging
Choosing assets so that the total values of assets and liabilities is same under all circumstances
Problems when cashflow matching using government bonds include:
assets may not fully cover the liabilities
the term of the liabilities may extend longer than the term of available bonds
there may be gaps between the maturities of available bonds
there may be a credit risk with government bonds
there is a risk of change in tax status of government bonds
there may be a "mark to market" risk between the valuation of assets and valuation of liabilities
using swaps for cashflow matching
advantages
swap durations can be longer than the duration of the available bonds
the costs of a swap portfolio can be less than that of a bond portfolio
full duration hedging can be achieved even if the scheme is underfunded
swaps are flexible, particularly with respect to exact term of the swap.
using RPI swaps, the approach can be extended to match inflation-linked liabilities
swaps can be more liquid than bonds
Disadvantages
ISDA agreements can be expensive and time consuming
Swaps may require collaterisation
closing out a swap can be harder than selling a bond
counterparty risk exists with the banking counterparties
institutions usually pay floating (and receive fixed) which means that the assets have to earn LIBOR- this is not always easy
basis risk exists between the swap yield curve and the bond yield curve
Liability-driven investment (LDI)
Approach to setting investment strategy, where the asset allocation is determined in whole or in part to a specific set of liabilities
Under an LDI approach it is possible to closely match:
the interest rate sensitivity (duration) of the liabilities
the inflation-linkage of the liabilities
the shape of the liabilities
Can take cashflow matching or balance sheet hedging approach
Non-investment risks such as longevity tend to remain
Dealing with the other risks
interest rate or inflation hedging
longevity swaps
longevity insurance policies
Dynamic liability benchmarks
benchmarks that vary with changing nature of liabilities
intermediate position between conventional "static" benchmarks and full liability hedging
Important in relation to currencies
may lead to desire to hold higher % of liquid assets, so as to be able to respond to changing circumstances