Asset liability (or cashflow) matching and portfolio immunisation are two methods insurance and pension fund managers use to ensure they can pay their liabilities.
To actuaries, the people who must calculate these things, it is the stuff of heroes. In 2003 their professional body, the Institute and Faculty of Actuaries, voted the inventor of immunisation theory, Frank Redington, the greatest British actuary ever.
Redington, who died in 1984 after a career at insurance company the Prudential, secured more votes than all three of the other candidates put together.
So, who better to turn to for an explanation of immunisation and asset liability (cashflow) matching, than the Institute and Faculty of Actuaries?
Cashflow matching, as it is colloquially known, relates to matching the asset and liability cashflows. The institute refers to it as asset liability matching (ALM).
ALM involves assessing the type of cashflows expected to arise from the entity’s liabilities – the amount it must pay out in pensions for example. Step two is to structure assets with cashflows that match or correspond to the liabilities.
The aim is then to reduce risks arising from asset cashflows being ‘inconsistent’ with liability cashflows.
There are a number of cashflow factors to consider with ALM:
The cashflow amount and term (timing) could be considered together. If a liability of £10,000 is due to be paid in one year’s time, then having assets that generate a cashflow of £10,000 also in one year’s time could be appropriate.
If, instead, asset cashflows generated just £8,000 in a year’s time, then there would be a cashflow shortfall to meet the liability. A further £2,000 would have to be found from other assets to meet the liability.
Similarly, if the assets generated a cashflow of £10,000 but in 18 months’ time, again there would be a liability shortfall. If the entity held all its assets in property, some property might have to be dis-invested at short notice to generate the required cashflow at the right time.
So matching cashflows by amount and term helps avoid cashflow shortfalls and reduce liquidity risk.
Both the timing and amount of future cashflows could be subject to uncertainty – and here ALM techniques are modified by using expected values, or projecting different scenarios of the amounts and timing.
Nature of cashflows
The nature is also important, but more subtle. Nature refers to whether cashflows are fixed, or real – are they likely to increase with some form of inflation?
For example, insurance policies with pre-defined sums assured could have fixed /nominal liabilities such as a fixed amount of £10,000 to be paid in five years’ time.
Alternatively, a pension liability could currently be £1,000 per annum, but increasing in line with the RPI index. In this case, the cashflow is not fixed but ‘real’ and dependent on future inflation.
The cashflow in five years’ time will be £1,000 plus whatever growth in inflation applies between now and then.
ALM means matching fixed liability cashflows with fixed asset cashflows, and similarly matching real (index/ inflation-linked) liability cashflows with real asset cashflows. A real asset would be one where the future asset cashflows were also affected by future inflation.
Currency of cashflows
If an entity has liabilities denominated in US$, then using ALM would mean you hold equivalent assets also in US$. Otherwise, the entity would run the risk of being exposed to exchange rate fluctuations.
For example, if a liability of $10,000 is due in one year’s time, then with a £/$ exchange rate of 1.3, assets yielding £7,692 in a year’s time would be sufficient.
But if the £/$ exchange rate fell to 1.1 in a year’s time, then the assets would yield $8,461, giving rise to a shortfall of $1,539.
The exchange rate could work the other way, but being subject to the vagaries of exchange rate movements introduces the entity to currency risk.
Using ALM to match asset and liability cashflows exactly is one way of avoiding cashflow mismatches. However, it is not always practical or possible to find sufficient assets with cashflows that exactly match the liabilities.
One alternative approach is to use immunisation techniques. Here, rather than having to match cashflows by timing/amount exactly, an alternative portfolio of assets could be structured to immunise the entity from movements in interest rates.