Asset-liability management (Limitations on investment imposed by the…
Two 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 (1), the investments should also be selected to maximise the overall return on the assets, where overall return includes both income and capital gain.
Direction, i.e. a positive or negative cashflow (being clear on viewpoint)
Nature, e.g. fixed or inflation-linked, lump sum or regular payments
Term and timing
Certainty (of both timing and amount)
Net liability outgo
Benefits (or claims) + expenses - contribution (or premium) income
Guaranteed in money terms
Guaranteed in terms of an index, e.g. a price or earnings index (may or may not be a published index)
Discretionary, e.g. bonuses on with-profit contracts or discretionary pension increases provided by a defined benefit scheme
Investment-linked, e.g. unit-linked liabilities
Asset matches for discretionary liabilities
Assets expected to yield a high, real return, e.g. equities or property.
The choice will also be affected by policyholders' expectations and the provider's appetite for risk.
Asset matches for investment-linked liabilities
The provider can avoid any investment matching 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 achieve this.
Impact of free assets on investment strategy of an insurance company
free assets act as a cushion against adverse investment experience
with free assets, it may be possible to depart from the matched strategies suggested previously in pursuit of higher expected returns (and hence higher benefits, lower premiums or higher profits). Alternatively the insurer might choose to de-risk, i.e. use the free assets to move to a more conservative, better matched strategy.
However there need to be sufficient free assets since mismatching and investing in higher risk/ higher return assets increases the risks of not meeting guaranteed liabilities and of insolvency.
there may be competing uses of free assets (e.g. writing new business, providing discretionary increases to policyholders) which limit the potential to mismatch.
In some territories, the mismatching of investment-linked liabilities may not be permitted by law or by regulation.
Mismatching reserve determination
Select assets held that are equal in value to the liabilities.
Recalculate the values of these assets and liabilities under stresses to economic factors such as interest rates,
If the stressed asset value is less than the stressed liability value, the difference is the mismatching reserve that should be held.
perform a stochastic simulation of the markets in which funds are invested using an economic scenario generator,
By inspecting the tails of the stochastic output, determine the mismatching reserve as the amount of free assets that is needed in order to just prevent insolvency at the desired probability level.
Limitations on investment imposed by the regulator (TECH SCAM)
Types of assets that a provider can invest in
Extent to which mismatching is allowed
Currency matching requirement
Hold certain assets, e.g. government bonds
Single counterparty maximum exposure
Custodianship of assets
Amount of any one asset used to demonstrate solvency may be resticted
involves structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the net outgo in respect of the liabilities under all circumstances.
Reasons why pure matching is not normally possible
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 as long term that suitably long-dated assets do not exist.
a deterministic or stochastic model that can be used to help an institutional investor set an investment strategy.
the model will have a specified objective with a measurable target that refers to assets and liabilities, a time horizon and a probability confidence interval (if a stochastic model). For example, the value of the assets less the value of the liabilities must be greater than zero 95% of the time
for a particular investment strategy, an ALM projects asset proceeds and liability outgo cashflows into the future and values them
the model is run and re-run, each time changing the investment strategy, until the stated objective is met.
the model should be dynamic, i.e. allow for correlations between asset and liability cashflows.