Liability driven investing pimco all asset

Published 31.08.2019 в Analyse forex euro franc suisse

liability driven investing pimco all asset

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The following elements are crucial in this regulatory reform: Total balance sheet approach i. Using these elements, several countries have developed their own solvency tests. Such tests typically use pre-described stress scenarios for the different risk factors e. Institutions should demonstrate that their surplus is sufficiently large to adsorb these shocks and prevent the occurrence of a negative surplus.

The combined effect of the different shocks is determined using assumptions about the correlations between the different risk factors. Large institutions are also encouraged to develop their own internal models to determine the required capital. The Netherlands has been a frontrunner in these developments by adopting the FTK solvency testing framework, which focuses on overall balance sheet risks including all assets and liabilities.

The upcoming European Solvency II guidelines for insurers, expected to be in place in , will incorporate these local frameworks. Footnote 3 Anticipating these new requirements, financial institutions in many European countries have now moved towards LDI solutions. The idea behind these solutions is that the required capital is reduced by properly matching the liabilities, which makes the company less vulnerable in case of adverse economic situations.

Van Bragt et al. This stresses the need to properly hedge the potentially very high costs of these embedded options. The academic literature with respect to the application of LDI is still rather small. Amenc et al. Footnote 5 apply the LDI concept to insurance companies and private wealth management. They argue that the LDI concept can be applied successfully in this case and give examples of the effectiveness of both static and dynamic LDI strategies. They show that, given a surplus optimisation perspective, more efficient asset mixes can be found by introducing a liability-hedging portfolio LHP in the menu of asset classes.

LDI solutions thus consist of three basic building blocks cash, LHP and a performance portfolio , as opposed to the allocation to standard asset classes as in the context of regular surplus optimisation techniques. Mindlin Footnote 6 discusses the relevance of LDI solutions for pension funds. He argues that the LDI concept is inadequate for open-ended pension plans since matching assets for ongoing plans rarely exist.

For example, if the matching asset for an ongoing plan existed, it would contain bonds indexed to wage inflation with maturities of 50 years or more. Mindlin therefore concludes that the LDI approach is more appropriate for terminated plans or plans for which termination is likely. He also stresses that the impact of other risk factors contribution risk, solvency risk, accounting risk, etc. Boender Footnote 7 is also critical of a straightforward application of LDI techniques for pension funds.

He points out that LDI is not a completely new concept at all: asset and liability management ALM for pension funds has given liabilities a central role a long time ago. Chapter 18 by Boender et al. Boender7 also demonstrates, with a practical example, that most LDI solutions for open-ended pension funds lead to solutions that are too risk-averse and, as a consequence, too expensive.

He remarks that it is common practice that, given an agreed-upon asset allocation, sponsors contribute more in case of a decreasing funded ratio. This risk-reducing effect for the pension plan is not considered in LDI solutions. As a consequence, an LDI solution may be overly conservative.

A second risk-reducing mechanism, also frequently ignored by LDI, is the postponement of indexation in case of low funded ratios. As a third factor, new pension rights may improve a weakly funded ratio if the actuarial price is paid for these rights. If these mitigating effects are ignored, the resulting asset allocation may become overly conservative given a certain long-term ambition. This paper contributes to the existing literature by examining the consequences of LDI for life insurers.

Our approach is similar to Boender7 in the sense that we use a scenario approach Footnote 10 to study the effectiveness of LDI. Our results are, however, much more positive and indicate that the LDI concept has several major advantages for life insurance companies: Dividing the assets in an LHP and a return portfolio RP creates a natural benchmark for the LHP portfolio the liabilities.

When setting up a proper LHP, one has to explicitly address all risks embedded in insurance liabilities, including the options embedded in these liabilities. When the liability-driven risks are covered by the LHP, the resulting return assets can be optimised using well-known Markowitz optimisation techniques or equity hedge strategies.

In one sense, constructing LHP portfolios for life insurers is more straightforward than for pension funds since most claims are in nominal terms. The issue of hedging inflation risk is therefore of less importance although exceptions exist, for example in the case of insured pension contracts with indexation. Complicating issues like the effect of risk-sharing with a sponsor and the effect of conditional indexation are also absent or of less importance since typically no sponsor exists and claims are not adjusted to inflation.

Stated differently, for most insurance companies it is clear what the actual liability is and how the market value of this liability should be determined. Footnote 11 In another sense, LDI portfolios for insurance companies are relatively complex compared to LHP portfolios for pension funds due to options embedded in insurance contracts.

We demonstrate in this paper that matching these embedded options with the proper financial instruments like swaptions, stock options or other hybrid instruments is possible, although some mismatch risk can of course remain in practice. We also show that overall risk is determined to a large extent by the market value of the matching assets compared to the market value of the liabilities.

If these market values are equal, overall risk is minimised. If the volume of the matching assets becomes smaller than the value of the liabilities, overall risk and return increases strongly because more leverage is created on the return balance sheet. The remainder of this paper is organised as follows. We first explain in the next section how a simple LDI balance sheet can be constructed by rearranging the assets on a separate matching and return balance sheet.

We then investigate in the subsequent section how the matching assets the LHP can be optimised in such a way that the market value of the liabilities is replicated for a large set of economic scenarios. Using this optimised LHP, we study risk and return on the overall balance sheet in the section after that. The last section concludes.

Construction LDI balance sheet Example balance sheet The fair value balance sheet in Figure 1 will serve as an example in this paper. Figure 1 The fair value balance sheet serving as an example in this paper. Note: We here consider a stylised balance sheet of an insurance company with i products without additional optionalities like simple annuities , ii products with additional profit-sharing based on the interest rate level and iii unit-linked investment contracts with guarantees.

The stylised asset mix consists of 70 per cent fixed income and 30 per cent bonds. Full size image The fair value reserve first of all consists of a basic reserve for the expected guaranteed premiums, costs and benefits value: We do not include an MVM to keep the analysis a simple as possible. Footnote 12 For simplicity, we also do not consider new business but only the runoff of the existing policies.

This is not to say that the effect of new business can be ignored in practice: for going-concern ALM analyses this aspect should definitely be taken into account. When an insurer has selected an LDI solution it is, obviously, also extremely important to update the LHP for the existing policies with additional liability hedges when new business arrives.

For brevity, we also ignore the effect of policy-holders who surrender their policy. Surrender is an important phenomenon, however, which should be considered in practice. The insurer of this example has a significant number of insurance policies with additional profit-sharing in case of high interest rates.

Because this profit-sharing component is essentially an interest rate option, an additional reserve is required value: Footnote 13 There is also a reserve for embedded options in unit-linked policies value: Footnote 14 These options are important when the policy-holders receive a guaranteed return on their investments or a guaranteed capital when the contract ends insurers must compensate a shortfall with respect to such a guarantee. As a compensation for giving this guarantee, this insurer receives a fixed guarantee fee.

Footnote 15 The assets consist of 30 per cent stocks value: and 70 per cent fixed income value: These assets are annually rebalanced to the initial 30 per cent — 70 per cent mix. Currently, no interest rate derivatives or stock options are used by the insurer. On the basis of this balance sheet, the insurer's surplus is equal to Because the legally required solvency level according to the Solvency I guidelines is equal to 46, the Solvency I ratio is equal to per cent.

Rearranging the balance sheet We now apply the LDI concept and split the balance sheet in a return and a matching balance sheet. Figure 2 shows the effect of this procedure. Figure 2 The insurer's balance sheet, but now from an LDI perspective. Note: The balance sheet is divided in a matching balance sheet with the liabilities and fixed income. The other assets stocks and the surplus are part of the return balance sheet. Because the value of the fixed income assets is smaller than the market value of the liabilities, a fictive cash position is added to the matching balance sheet.

This causes a short cash position i. Fixed income thus naturally belongs to the LHP, since these assets are used to match the interest rate sensitivity of the liabilities. The remaining assets stocks are part of the RP. This fictive cash position is needed to match the volume of the liabilities. Because theoretically liabilities are exactly replicated by the corresponding assets, the matching assets should have the same volume as the liabilities. A cash position, which has almost no interest rate sensitivity, can be used to correct a volume mismatch with the liabilities without interfering with the interest rate hedges in the LHP.

Note that this cash position also appears on the return balance sheet, but on the opposite side. This implies that we effectively create more leverage on the return balance sheet when the volume mismatch on the matching balance sheet increases. Due to this added leverage, the risk and the expected return on the return balance sheet increases.

Modelling credits The above picture changes if the fixed income investments partly consist of credits. These more risky investments can, however, also be modelled within an LDI framework by decomposing them in a risk-free Treasury bond portfolio plus a stochastic excess term that models the additional risk and return associated with credit bonds. This stochastic excess term can be modelled conveniently in the RP with a long credits—short Treasury position. An example is given in Figure 3.

Figure 3 The effect of credits on the return and matching balance sheet. Note: We here decompose the credit portfolio in a risk-free Treasury bond portfolio and a stochastic excess term. The fictive Treasury bonds are placed in the LHP; the stochastic excess term is modelled in the RP with a long-short position.

Full size image We here assume that 50 per cent of all fixed income investments consists of credits. The long credits—short fictive Treasury position in the RP models the stochastic excess term associated with credits.

Modelling surrender In practice, the construction of LDI portfolios for life insurers is complicated due to embedded surrender options. For example, policy-holders in Europe are often able to surrender their policy in return for the book value of their policy although hefty penalties may apply. This creates an incentive to surrender the policy when the market interest rate is high and the book value of the contract exceeds the market value.

This embedded option, when exercised, can lead to a significant outflow of funds. They also remark that in practice it is difficult to precisely calibrate the scenario-depending surrender cash flows due to limited historical data on the behaviour of policy-holders. Given a calibrated model, an LDI portfolio could be constructed, however, which counteracts the effect of surrender.

Such a portfolio should consist of interest rate derivatives, like caps of payer swaptions, which approximately mimic the contingent surrender cash flows for high interest rate scenarios. For the construction of an appropriate portfolio with caps and swaptions a replicating portfolio technique can be used. For more information about this technique, see Oechslin et al. Footnote 16 and Schrager. The value of the fixed income assets plus the fictive cash position should theoretically be equal to the value of the liabilities for all future scenarios.

In other words, the surplus of the matching balance sheet should always be equal to zero. As a test, we generate 1, scenarios for interest rates and stock returns and analyse the evolution of the surplus of the matching balance sheet. Figure 4 shows the results of this stochastic simulation. Figure 4 Evolution of the surplus of the matching balance sheet. Note: We here consider 1, different economic scenarios.

Note the negative impact of a decreasing interest rate on the surplus. Full size image Obviously, this simple LHP is not robust with respect to future economic developments. Especially note the negative impact of a decreasing interest rate on the surplus. This scenario is a typical example of a low interest rate scenario see Panel A.

To further analyse the interest rate sensitivity of this insurer we evaluate the effect of a parallel change of the interest rate curve at the current point of time Figure 5 The impact of parallel shifts of the interest rate curve on the matching balance sheet.

Note: Note that the interest rate mismatch between assets and liabilities becomes large for low interest rates. Figure 5 clearly shows that there is a large interest rate mismatch between the assets and liabilities, resulting in a strongly negative surplus for low interest rates. Minimising the duration mismatch We now add a layer of interest rate swaps to the LHP to mitigate the interest rate risk. These swaps are bought a pari i. We select those swaps that minimise the duration mismatch of the assets in the LHP fixed income plus the additional swaps with the basic reserve the guaranteed cash flows.

The effect of this swap construction is shown in Figure 6. The interest rate sensitivity of the basic reserve is now properly matched at the current point in time and a negative surplus is only caused by high option values for low or high interest rates.

Figure 6 The impact of an additional swap construction on the interest rate sensitivity of the matching balance sheet. Note: The interest rate sensitivity of the basic reserve is now matched using the existing fixed income assets and an additional layer of swaps. The yearly withdrawals then become the liabilities that the LDI strategy must focus on. More specifically, the focus should be on the assurances made to pensioners and employees.

These assurances become the liabilities the strategy must target. There is not one agreed-upon approach or definition for the specific actions taken in regard to the LDI. Pension fund managers quite often use a variety of approaches under the LDI strategy banner. Broadly, however, they have two objectives. The first one is to manage or minimize risk from liabilities. These risks range from a change in interest rates to currency inflation because they have a direct effect on the funding status of the pension plan.

The second objective to generate returns from available assets. At this stage, the firm might seek out equity or debt instruments that generate returns commensurate with its estimated liabilities. The easiest option for the firm is to invest the funds at its disposal into an equity investment that generates the required returns.

Alternately, it can use an LDI approach to estimate split its investment into two buckets. The first one is a defined-benefit income instrument for consistent returns as a strategy to minimize liability risk and the remaining amount goes into an equity instrument to generate returns from assets. Since the goal of an LDI strategy is to cover current and future liability risk, theoretically, it may be possible that the returns generated are moved into the fixed-income bucket over time.

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