Asset-liability modelling and investment strategy for insurers and pension schemes
Asset-liability modelling asks a single question: which asset portfolio best funds a given liability cash-flow profile, given the investor's risk appetite, capital and regulatory regime? The exam tests both qualitative strategy design and the ability to quantify mismatch.
Insurers
- With-profits: assets must support asset shares, smoothing and any guaranteed minimum; the estate absorbs residual risk, so strategy balances policyholder expectations against solvency.
- Unit-linked: the policyholder bears investment risk; the insurer's exposure is expense, operational and any guarantee.
- Annuity writers: long-dated fixed and inflation-linked liabilities. The Solvency II matching adjustment lowers the discount rate on eligible assets - those with fixed, predictable cash flows - capturing an illiquidity premium, but constrains asset choice and diversification.
- Solvency II: best estimate liabilities plus risk margin, with the SCR driven substantially by spread, interest rate, inflation and equity stresses.
Pension schemes
- DB: funding strategy, employer covenant and investment strategy form integrated risk management. De-risking typically follows a flight path: as funding improves, shift from equities into bonds and hedges.
- LDI: swaps, repos and gilts used to hedge interest rate and inflation sensitivity, usually with leverage. The 2022 gilt sell-off exposed collateral waterfall risk when asset values fall and collateral calls arrive at once.
- DC: members bear risk; default glidepaths de-risk towards annuity purchase or drawdown.
Worked example: hedging the surplus
Liabilities have PV 100m and duration 18; assets are 90m with duration 6. The asset duration needed to match liability sensitivity is (18 × 100)/90 = 20. Since current duration is 6, the scheme must add roughly 14 years of duration, typically via swaps or a leveraged gilt portfolio. The leverage is the mechanism; the collateral requirement is the cost, and it must be stress-tested.
Traps
Hedging liability duration rather than surplus sensitivity. Ignoring matching-adjustment eligibility constraints. Assuming technical provisions equal a buyout quotation.