Asset-liability modelling and investment strategy for insurers and pension schemes
This domain tests the link between liabilities and investment strategy. You must be able to choose between cashflow matching, duration matching and broader asset-liability modelling, and to explain how funding and solvency constraints change the optimal portfolio.
Core rules
- Immunisation requires matching present values, durations and, ideally, convexity; duration matching alone leaves curve-risk.
- Cashflow matching is more precise but can be costly and inflexible; it suits predictable, long-dated liabilities.
- Liability-driven investment uses swaps, gilts and repo to hedge interest-rate and inflation sensitivity without buying the underlying cash bonds.
- A funding-level glidepath de-risks as funding improves, locking in gains rather than chasing return.
- Insurers must consider regulatory capital, matching adjustment eligibility and the volatility of the surplus, not just expected return.
Worked example
Assets are worth 900m with duration 8; liabilities are 1,000m with duration 15. Asset dollar duration is 7,200 and liability dollar duration is 15,000, so the surplus is badly exposed to falling rates. To immunise, the required asset duration is (1,000 x 15) / 900 = 16.67. The scheme could extend duration with long-dated swaps or gilts. If it instead buys more equities, it increases expected return but widens the duration gap and surplus volatility.
Traps
- Matching nominal liabilities when they are real.
- Confusing accounting funding with cashflow solvency.
- Ignoring convexity when duration is long.
- Assuming a hedge is perfect when basis risk remains.