Hi, I would like to have more detailed explanations on the asset-liability matching for deferred annuities. According to the Core Reading, the liabilities of deferred annuities can be matched using very long-term assets or swap instruments. From my understanding, I interpreted this as: Very-long term assets: bonds or bond-like assets whose terms can cover the whole term of the deferred annuity, which includes both the vesting period and the later annuity period. The term required for assets needs to be very long due to the existence of the vesting period. Swap instruments: I don't really understand how to use swaps to match liabilities of deferred annuities. I think we can use interest-rate swaps to pay floating rates in exchange for fixed rates. Hence, we can guarantee that the sum we get at the vesting date is as expected and then at that vesting date, we will use that sum to invest in bonds to match the immediate annuity in the same way as matching normal immediate annuities. Is this true? Thanks, Tu
Hi - yes I reckon your thinking is along the right lines here. I personally interpreted it as meaning that the company could match for as far into the future as it can go using bond instruments, but with that resulting in there being an amount available at some future point (possibly arranged to be the vesting date) that will need to be reinvested in order to meet the annuity payments due after that point. By using a (forward) interest rate swap, it can lock into a known future yield - hopefully set at whatever it needs in order to be able to pay the promised annuity amounts. Otherwise there is a risk that the company will be unable to reinvest at an acceptable yield at that future point in time.
