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Liability driven investing for life insurers australia

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So pensions sold bonds among other things to raise that cash, pushing yields up, making hedging trades even more expensive, and requiring even more collateral. As Toby Nangle pointed out on Wednesday , The Pensions Regulator said in that 62 per cent of the biggest UK pensions had at least some exposure to interest-rate swaps, a type of derivative.

But interest-rate hedging with swaps is a pretty vanilla type of derivative use, all things considered. Interest-rate swaps are used widely among the large US and UK investors who want to match their assets with liabilities; think pension funds and insurers. Pensions would simply buy bonds that would pay out what they need to pay pensioners, when they need to pay pensioners.

Need a lump-sum payment in the future? Buy a zero-coupon bond that matures on that date! That means pension funds need to take extra risk. There is an entire industry built to tell them how to take this risk, and there are many different options, like private equity, hedge-fund strategies, and notoriously, the rare kickback scheme.

Beyond the uncertainty around what they will owe, many are underfunded, meaning they need to put cash into riskier assets to earn a return and make up for that difference. That is probably a large part of the reason that pensions of the biggest US companies were actually more than fully funded as of August 31 , according to consultancy Millman, which estimated that assets totalled per cent of liabilities.

Hold on. LDI is based on a quant-y accounting gimmick? Barring widespread defaults, bonds do have a predictable stream of cash flows. So in a perfect quantworld, a pension would own a risk-free government bond that pays what it owes a retiree, on the day it owes it to them. Then who cares if the price of the bond goes down today? And even here on earth, a company that freezes its defined-benefit plan can then offload its matched liabilities to a life insurer who can perform insurance magick maths to ensure the payouts happen for a fee.

Works well, right? But adding interest-rate swaps to the mix sounds like a way to pretend you have that bond portfolio without actually putting up the capital to invest in a bond. Or forgoing the potential equity returns. Like who? If you think you might know, please do get in contact. We found that the mismatch of this portfolio with the actual liabilities is huge due to: i a duration mismatch; and, ii profit-sharing and guarantee options that are embedded in the liabilities.

The duration mismatch can be minimised efficiently using a layer of linear swap contracts. In addition, a year swap is bought in each future year to update this initial hedge. The embedded options can be matched by nonlinear products such as payer swaptions for the profit-sharing option or a mixture of receiver swaptions and equity put options or hybrid options for the unit-linked guarantees.

The resulting, optimal LHP portfolio is shown in Figure It is important to note that with a relatively modest investment 63 the downside risks on the matching balance sheet can be reduced significantly. Note : A layer of swaps is bought a pari i. In addition, a year swap is bought in each future year to update this initial hedge these instruments are not visible on the initial balance sheet. The embedded profit-sharing and unit-linked options are hedged using synthetic options which mimic the behaviour of the embedded options in the liabilities.

Note : Note that the downward risks on the matching balance sheet are reduced significantly by adding swaps and hedges for the unit-linked and profit-sharing options in the liabilities. Interestingly, the added option hedges do not appear to have a negative impact on the average surplus on the matching balance sheet compare the average values in Panels A and B.

In fact, the average surplus increases slightly because the strongly negative scenarios are almost entirely eliminated the upside scenarios are also suppressed, but this effect is less pronounced. Setting up a proper LHP portfolio thus appears to be very attractive: the downside risks are suppressed significantly, while the average return of the LHP plus the fictive cash position remains sufficiently high to match the expected return of the liabilities.

We now proceed with an analysis of the complete balance sheet. For simplicity, we consider the stylised situation in which the insurer does not pay taxes or dividends. The results are shown in Figure Evolution of the surplus for 1, different economic scenarios. Panel A shows the evolution of the surplus in case of the original balance sheet in Figure 1. Small differences occur, however, because annual rebalancing has a different effect when we consider a single balance sheet with annual rebalancing as in Panel A or two different balance sheets as in Panel B.

Panel C clearly shows the effect of the optimised LHP in Figure 11 : the downside risks are reduced significantly. To further reduce the risks, we can reduce the percentage of stocks and invest more money in fixed income. This has almost no impact on the risks on the matching balance sheet because the interest rate risks are minimised by the swap construction in the LHP.

Footnote 21 The impact on the RP balance sheet is significant, however, because the amount of leverage decreases as well as the allocation to stocks. This effect is illustrated in Figure 14 , where we show the evolution of the surplus on the matching and total balance sheet. Impact of the volume of the liabilities that is matched by the LHP.

Note : In Panel B and D the volume of the liabilities is completely matched with fixed income. This has almost no effect on the mismatch risk on the matching balance sheet compare Panel A with Panel B. The effect on the total balance sheet is significant, however, because leverage on the RP balance sheet is eliminated in Panel B and D and the allocation to stocks decreases.

This reduces both the downside risk and the expected return. In Panels A and C we consider the situation in Figure 11 , where 87 per cent of the volume of the liabilities is matched with fixed income. In Panels B and D we consider the situation where per cent of the volume of the liabilities is matched i. Comparing Panel C with Panel D shows that the downside stock risk decreases when we reduce the amount of leverage and the exposure to stocks.

This, however, has a negative impact on the return: the average surplus after ten years is lower in Panel D than in Panel C. The average return on the surplus also decreases: from 9. It is possible to further reduce the downward surplus risks using an appropriate put or collar stock option strategy.

As an example, we evaluate results for two different put option strategies. The first put strategy protects per cent of the stock portfolio with a three-year put option. The strike of this option is equal to 70 per cent of the index level. The second put strategy consists of protecting 50 per cent of the stock portfolio with a one-year put option.

The strike of this option is equal to 95 per cent of the index level. All options are financed by selling a part of the stock portfolio. When an option expires a similar option is bought. The options are priced using the familiar Black and Scholes Footnote 22 formula. For the Black-Scholes volatility we use the scenario volatility plus a surcharge. This surcharge represents the average difference between the log volatility of the underlying index and the implied volatility of traded options.

We use an estimate of 3. Results for these put strategies are shown in Figure Panel B is the reference situation and shows the evolution of the surplus for the optimised LDI balance sheet in Figure In Panel C we study the effect of adding the three-year put option strategy to the stock portfolio on the return balance sheet. Panel D shows the results for a one-year put option strategy. Note the significant risk-reduction in Panels C and D, especially in the first years.

For example, the selected stock index scenario in Panel A has a large negative effect on the surplus in Panel B in the first years. This effect is mitigated in Panels C and D due to the protection by the put option. In the long run, the risk-reducing effect of both option strategies becomes smaller. A solution might be to use options with a long maturity e. The market liquidity for such options is very limited, however, so option strategies with short maturity options are often favoured in practice.

The effect of two different put option strategies on the evolution of the surplus on the total balance sheet. In Panel C and D we study the effect of adding a put option strategy to the stock portfolio on the return balance sheet. In Panel C we protect per cent of the stock portfolio with a three-year put option. In Panel D we protect 50 per cent of the stock portfolio with a one-year put option.

The strike of this option is 95 per cent of the index level. Note the risk-reduction in Panel C and D, especially in the first years. The impact on the return on equity is negative for both put strategies: the average surplus after ten years is significantly lower in Panels C and D than in Panel D. The average return on the surplus also decreases significantly: from 9. The risk reduction thus clearly comes at the cost of a lower return on equity. It should also be noted that the implementation of a protective put strategy should be done with care.

The option prices implied volatilities vary constantly and can reach very high levels when protection is needed most i. It is thus advisable to use a layered option strategy to avoid that all options should be renewed at the same point in time. It is, of course, also useful to construct a more diversified RP, for example by using Markowitz optimisation techniques. Footnote 24 This approach is well established and is therefore not explored further in this paper.

The LDI concept can be used to divide the asset allocation problem for a life insurer into separate, more tractable problems. This improves the complicated asset allocation decision. The basic idea behind LDI is to split the balance sheet into two separate balance sheets: one for the liabilities and the matching assets and one for the other return assets and the surplus.

Using a realistic example, we show how an insurer can match the liabilities, including all embedded options, using an LHP in combination with a fictive cash position. The fictive cash position also emerges as a short cash position i. We demonstrate that setting up a proper LHP portfolio is very attractive because the liability-driven risks are suppressed significantly while the average return of the LHP plus the fictive cash position remains sufficiently high to match the expected return of the liabilities.

The final step is an optimisation of the assets on the return balance sheets. Since the liability-driven risks are already suppressed by the matching assets, these assets can be optimised using well-known Markowitz optimisation techniques or equity hedge strategies. Pillar I concerns the measurement of assets, liabilities and the required capital. This pillar thus focuses on the more quantitative regulatory aspects. Pillar II concerns the supervisory review process and therefore focuses on the more qualitative aspects.

Pillar III addresses disclosure requirements: transparency, open information, etc. For example, the CRO Forum recently released a paper concerning the determination of the market value of insurance liabilities. The CRO Forum's position is that all cash flows should be separated into hedgeable and non-hedgeable components and valued using either mark-to-market or mark-to-model approaches. Components of the cash flow for which hedging instruments are available in the financial markets should be valued with reference to the prices of those instruments or using the same option pricing techniques and parameters that are used in valuing the hedge portfolio in the financial markets.

For components of the cash flow that are subject to non-hedgeable risks both financial and non-financial a mark-to-model adjustment the market value margin MVM should be added to the best estimate value of the cash flow. Risks that can be hedged or diversified away should have no impact on the MVM. The profit-sharing options are priced using an adaptation of Black's option formula see Hull, The unit-linked options are priced using the formula proposed by Schrager and Pelsser The present value of these guarantee fees may become larger in an absolute sense than the unit-linked reserve.

What is liability driven investments LDI? How do liability driven investments work? Reduced volatility of cash contributions Reduced volatility of earnings per share and balance sheet items Can facilitate future annuity purchase Assets are maintained and can be used to fund longevity insurance premiums Assets can be optimized to provide additional yield and diversification. Where to start? Who provides LDI solutions? Learn about longevity insurance.

In the spotlight. Get the latest insights on managing risk in your DB pension plan Sign up. Are you a member of the media? Please contact: Laura Torchia laura. General contact information. For general inquiries about DBS, please contact: Email: db. Like BitM is exploring form of think can complete money you access.

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Liability driven investing for life insurers australia Please review the Terms of Use of this site for additional details. Being able to perform granular analysis of trade structuring and generate a profit and loss statement for the entire balance sheet helps firms measure the effectiveness of hedging strategies more accurately. The MetLife Investment Management entities may not be registered in Japan and may not intend to offer any services to investors in Japan. Pension funds are a cornerstone of the economy, helping scoop up huge amounts of stocks and bonds issued by companies that need cash to operate and grow. The yield on the benchmark year government bonds remains stubbornly above historic norms. This process of reviewing, and if necessary re-optimising, the benchmark to changes in the projected liability cash flows typically occurs every six months, but can be done more often if required and at any time on request. Hong Kong S.
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Horse racing results and bettingadvice If you are in any doubt about any of the content on this website, you should obtain independent professional advice. On Tuesday, the Bank of England bought just 1. We also recommend revisiting the liability benchmark when updated cash flows are available after the actuarial valuation so that any changes can be accurately reflected in the benchmark and strategy. It seems fair to say that the annuities liabilities are illiquid in nature as customers have no lapse option, so insurers can hold these assets to maturity without crystallising any losses as there is no specific rush to liquidate assets backing these liabilities. This website may contain or incorporate by reference information that includes or is based upon forward-looking statements.
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How does Liability Driven Investing help manage investment risks?

Dec 01,  · December 01, Liability Driven Investing for Insurance Companies. In this Q&A, Conning’s Head of Insurance Solutions provides insurers his insights on the use of liability driven investing, including investment strategies that insurers should consider. Liability-driven investing (LDI) often is used for complex rate-sensitive liabilities, such as those for a defined benefit pension plan. The retirement benefits for covered employees depend on many variables, such as years of employment, age at retirement, wage level at retirement, and expected lifetime. Dec 25,  · Section 2: Liability-Driven Investment Strategy. the following methods widely used in life insurance companies. 1. Duration matching. However, some lines of non-life business have long-term payout patterns, such as liability .