Chapter 20: Actuarial techniques (2)

Question 1

k)Actuarial techniques for developing an appropriate investment strategy

Outline what is meant by liability hedging and provide examples.

Liability hedging

Answer 1

• Liability hedging is where the assets are chosen in such a way as to perform exactly in the same way as the liabilities in all states and in respect of all factors that influence liability values.
• i.e., hedging unpredictable changes in liabilities that arise from unpredictable changes in factors that affect liability values.

Examples are:
- immunisation - assets chosen in order to reduce interest rate sensitivity
- currency matching or consideration of real or nominal nature of liabilities.

Question 2

k)Actuarial techniques for developing an appropriate investment strategy

Liability hedging

Question 3

k)Actuarial techniques for developing an appropriate investment strategy

Outline a common method used to hedge liabilities.

Liability hedging

Answer 3

• A common method - holding pf of bonds until maturity to meet pre-specified stream future payments.
• Where a liquid repo market exists for bonds used in the liability hedge, repo contracts can be used to release funds.
• In this way a leveraged exposure to bonds can be created without invesing the full market values.

Question 4

k)Actuarial techniques for developing an appropriate investment strategy

Explain why using cashflow matching using bonds can lead to difficulties.

Liability hedging

Answer 4

• Duration of available bonds may not be sufficient to hedge liabilities (reinvestment risk or liquidity risk)
• Expensive to purcahse all required bonds
• Bond maturities may have gaps between them and may required disinvestment and reinvestment…
• …e.g., hedge a 45 year liability with 30 year and 15 year bonds. but if rates are unfavourable at 30 year mark, proceeds may not be sufficient.
• Tax status of government bonds may worse
• Credit risk in gov bonds not reflected in liabilities
• Mark to market risk between the valuation of assets and liabilities

Question 5

k)Actuarial techniques for developing an appropriate investment strategy

Describe the advantages of using swaps (synthetic portfolio management) to improve cashflow matching.

Liability hedging

Answer 5

• Using RPI swaps, the approach can e extended to match inflation-linked liabilities
• swap durations can be longer than available bonds.
• swaps can be more liquid than bonds
• the costs of swap pf can be less than that of a bond pf
• full duration matching can be achieved even if the scheme is undefunded
• swaps are flexible, particularly with respect to exact term of the swap…
• …thus make it easy to match many liabilities in one swap.

Question 6

k)Actuarial techniques for developing an appropriate investment strategy

Describe the disadvantages and drawbacks of using swaps to improve cashflow matching.

Liability hedging

Answer 6

• ISDA agreements that are expensive and time consuming
• swaps may require collaterisation which may reduce liquidity
• closing out a swap is harder than selling a bond
• counterparty risk exists with the banking counterparties
• instituions usually pay floating (and receive fixed) which means that asset have earn LIBOR this is not always easy
• basis risk exists between the swap yield curve and bond yield curve.

Question 7

k)Actuarial techniques for developing an appropriate investment strategy

Outline other approaches that are used in liability hedging.

Liability hedging

Answer 7

• Holding short maturity assets and ‘rolling-over’ contracts…
  -…higher yielding assets
  -…but there is reinvestment risk
  -…roll-over process can result in higher transactional costs in the long-term
• Can meet liability payments linked to other indices with OTC or ET derivatives
• Continuous rebalancing and monitoring of the greeks

Question 8

k)Actuarial techniques for developing an appropriate investment strategy

Describe the different approaches to LDI that different investors may have.

LDI

Answer 8

Some investors will focus on matching cashflows, wherease others will focus more on balance sheet hedging, i.e., aligning the asset and liability sensitivies to interest rates and inflation expectations.

The latter approach is likely to result in the investor accepting a degree of cashflow mismatch in return for lower basis risk.

Question 9

k)Actuarial techniques for developing an appropriate investment strategy

Explain the term ‘liability-driven investment’.

LDI

Answer 9

LDI is not strategy or type of product but is an approach to setting investment strategy, where the asset allocation is determined in whole or in part to a specific set of liabilities.

Under the LDI appproach it is possible to closely match:
- interest rate sensitivity (duration) of liabilities
- inflation-linkage of liabilities
- the shape of the liabilities

Question 10

k)Actuarial techniques for developing an appropriate investment strategy

Explain how an LDI strategy would be implemented and ay risks that may remain.

LDI

Answer 10

Implementing an LDI strategy an investor would expect thhat changes in thee value of the assets closely match changes in the value placed on liabilities.

A combination of interest rate and inflation bearing assets can provide a match of projected benefits, effectively immunising the investor against changes in future interest rates and inflation.

There are many different approaches to managing LDI, although most investors tend to focus on swap portfolios or long duration bond management. it is possible to use repos to replace swaps in this process.

Non-investment risk such ass longevity tend to remain.

Question 11

k)Actuarial techniques for developing an appropriate investment strategy

Give examples of measures used by institutions to combat these other risks.

LDI

Answer 11

Measures include:
- interest rate and inflation hedging
- longevity swaps
- longevity insurance policies - exchange fixed payments (premiums or expected payments to annuitants) in return for floating payments (claims or actual payments to annuitants)

Question 12

k)Actuarial techniques for developing an appropriate investment strategy

Explain the relevance of dynamic liability benchmarks

LDI

Answer 12

• Benchmarks that change with the nature of liabilities
• Intermediate position between ‘static’ benchmarks and fully liability hedging.
• important in relation to curreries, where the nature liability pf changes rapidly as market conditions change.
• May lead to to a desire to hold high proportion of liquid assets, so as to be able to respond to changing circumstances.