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understanding refer to the ALM for discretionary benefits provided

S

Smith

Member
in Chapter 15 - Asset-liability management, page 12, Discretionary benefits
There are two sentence in this paragraph,
one is "if discretionary benefits are to be provided the main aim of the provider will be to maximising these and hence the investment strategy should therefore also do that." - my understanding is that what the provider maximising is the would-be discretionary benefits cash flow, rather than maximising the investment returns, and then what the investment strategy is to do is to ensure the future cash flow, which is the discussed ALM. Am I right?
the second one is "this means investing in assets that will produce the highest expected return." - i think it's not matched with the former sentence, that investing for liabilities with discretionary benefits in future should ensure the maximum benefit payment rather than maximising the investment returns. Am I right?
thanks for advise!
 
A good example of a 'discretionary benefit' is the terminal bonus on a with-profit life insurance policy. The key point is that it is discretionary: the insurer has no direct obligation to pay it (other than in order to meet policyholders' reasonable expectations) as it is not guaranteed in advance, and the amount that is paid is also at the discretion of the company with no guaranteed minimum level (other than, perhaps, that it is greater than zero).

Terminal bonus is mostly paid out of the investment returns that are earned on the assets backing the policy (the asset share), over and above the returns that have already been distributed either as part of the original sum assured or as a regular (guaranteed) bonus.

The insurer will want to aim to pay a high terminal bonus, in order to keep its policyholders happy (therefore better persistency) and to be able to attract new customers.

In order to do this, it has to achieve high investment returns on the assets backing the policy.

Its investment strategy can therefore be to invest in assets that have high expected returns. The fact that these are likely to be riskier assets doesn't matter too much - because the amount paid is discretionary. If returns are terrible, the amount of terminal bonus paid can be reduced.

You mention the insurer wanting to 'ensure' the future cashflow. But for a discretionary liability it isn't necessary to invest in order to meet that liability with certainty. So greater risk can be taken with the investment choice - subject, of course, to the insurer's risk appetite and the risk appetite of the customer (who might not accept a massively volatile potential terminal bonus outcome).

Hope that helps clear this up.
 
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