Asset-liability management and investment strategy
This domain tests whether you can align asset cash flows and risks with insurance liabilities, and explain the consequences of mismatch for solvency, earnings and liquidity.
Core concepts
- Matching: cash-flow matching, duration matching and immunization. Duration measures sensitivity to parallel yield changes; convexity captures curvature.
- Risks: interest-rate, credit-spread, inflation, currency, liquidity and reinvestment risk. Reinsurance recoverables and tax also affect the asset-liability position.
- Constraints: regulatory capital, accounting volatility, rating-agency expectations and policyholder reasonable expectations.
Worked example
Assets are £1,000m with duration 5; liabilities are £900m with duration 7; surplus is £100m. The duration gap is 5 − (900/1,000) × 7 = −1.3. If yields rise 1%, assets fall about £50m and liabilities fall about £63m, so the surplus rises about £13m, or 13% of surplus. That is helpful in this scenario but exposes the insurer to a fall in yields, so the board must decide whether the mismatch is intentional.
Traps that cost marks
Using book values instead of market values; ignoring convexity for large yield moves; treating illiquid assets as freely realizable; and omitting the duration of reinsurance recoverables or inflation-linked liabilities.
Exam tip
Always state the yield change, the duration basis and whether the effect is on surplus, capital or accounting profit.