Managing uncertainty of Asset and Liability world: Liability driven investment (LDI)

Typically, as a young professional, we set up savings for our children’s future. These savings are assets suitably invested in bonds, shares, gold, and real estate. The liabilities are usually future payment for college fees, and marriage. So, we can say that all of us are exposed to a bit of simple Asset Liability Management (ALM) in our lives.

ALM, as the name suggests, is the management of assets and liabilities in coordinated way; it is important for both the common man and the big corporate houses. In our personal lives, we would be managing small cash inflows and outflows, which do not include a lot of planning, uncertainties and government regulations. But what happens with big corporations like banks and insurance companies is quite different.

The Insurance Provider:

Let’s assume you are the owner of an insurance company and you are in the business of simple annuity product in India. The generic features of your product are:

  • The policy buyer is supposed to pay a fixed amount once while buying the Annuity Policy.
  • The policy holder will get the policy payout every six months on the agreed terms.
  • Policy maturity period is till the death of the policy holder. When the policyholder dies, the nominee receives the ‘sum assured’ (equal to Annuity premium value) and the last coupon payment.

For simplicity, let’s say, initially you sold just one Annuity policy in the market of sum amount ‘X’ and you are paying the biyearly coupon to the annuitant at the rate of say ‘A %’. Immediately invested the same amount ’X’ in twenty-year maturity government bonds. You bought the government bond because it has less credit risk or chance of default. The bond that you bought is paying you the coupon every six months at some fixed pay-out ‘B%’ ,which we assume is more than ‘A %’ implying that your outflow coupon value is less than the inflow coupon value. Hence, we can conclude that in favour of managing the two cash flows; one from the bond and the other from the Annuity Policy, you are earning the difference between the two coupon values.

Uncertainty of the Asset and Liability world:

In the above case, liability is the biyearly coupon value and the sum assured on the death of the policy holder.  The latter can happen any time so you must have the money ready with you every time to pay the liabilities; this is called the Liquidity Problem. On the death of the annuitant, you need to sell your portfolio (in this case the government bond you bought) to pay the `sum assured’ to the nominee.

The asset is the twenty-year maturity government bond. The coupon money you get from your bond does not change till the maturity of the bond, but the market value of your bond changes as the interest rate changes in the market; it may go up or down. Due to this, you face another risk that is called `Interest Rate Risk’. If the interest rate values go down, then your bond market value increases and your profit goes high, but if it goes up, your bond value will go down and you may have to face the crisis.

Asset and Liability Management Problem:

Above was a simple example of how the cash flow works in the insurance sector. The primary issue with ALM or cash flow matching is the duration of your portfolio or bonds, and the Annuity policy.

The big Insurance companies who have thousands of bonds, stock, other assets in their portfolio and thousands of sold Annuity policies will have a more complex ALM problem. Also, the kind of risk they are bearing depends upon the asset classes i.e. bonds, stocks, equities, derivatives, and cash etc.

In addition to the different risks, the biggest single factor explaining performance of your portfolio is simply the asset allocation decision that determined how much a fund should hold in stocks, bonds or cash etc.

Over and above all these, companies have one common goal – to maximize their wealth.

From a mathematical perspective, this complex ALM problem can be set up in an equation form involving non-negative variables which represent inflow and outflow of funds and carry-over of retained assets and funds from one planning period to the next.

Liability Driven Investment: A potential solution considering uncertainty

There are a number of established techniques to consider the ALM problem mentioned above. In simple words, LDI is a technique to allocate assets while keeping the liabilities in mind. So that finally you are solving your cash flow matching problem by buying a portfolio that will give you an inflow that matches or surpasses your outflow.  That only happens in the deterministic world because in the real world, the inflow from an asset and the outflow from liabilities are not known beforehand. You can just predict some future value called scenario.

The robust and stochastic formulation of LDI, considers the different scenarios of the liability and assets i.e. different values of mortality rate (death date) of the policy holders (Longevity risk),different values for the interest rate (Interest rate risk), equities, stocks and market indices (Market risk) at each cash flow balancing step of the planning horizon.

Hence, we can say that to avoid the financial quagmire, requires advanced and meticulous financial planning, and for large organisations LDI is invaluable.

We will look into further details of LDIOpt in the coming weeks…

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