NPV method- Asset Liability mismatch

[Ambitious]

Q/A bank -2, in the solution to Q 2.6 (ii) a, it says -

If a Net Premium method is used then the relative sensitivity of this method (Matching Assets and liabilities) means that one might actually reduce the RCR, not by matching, but by investing the Assets "too short", ie to match the low volatility of the statutory liabilities.

I am not clear about how the NPV method may affect the matching/sensitivity of assets and liabilities?

I have also read somewhere that whenever the NPV method is used (for Regulatory valuations), it affects the correlation between the assets and liabilities. I believe this and the above point relate to the same issue.

Any help would be appreciated.

Thanks

 

[b_colgan]

Hi Ambitious

I'm not an expert in Net Premium Valuation but I took it to come from the fact that the net premium is calculated based on the valuation assumptions including the valuation rate of interest. The net premium reserves remain fairly stable because any increase/decrease in the value of the benefits and expenses is offset by an opposite change in the net premium.

Investing short will give the liabilities a lower discounted meant term and so more stable values. You can estimate the change in your liabilities from an absolute change in the valuation interest rate from discounted meant term * change in valuation rate * market value. For example, liabilites of £100m with a 5-year discounted mean term will change by £5m if the valuation rate increases by 1%.

I guess that assets and liabilites are more strongly correlated from the net premium valuation method because you use the same interest rate.

Hope this helps

 

[Ambitious]

Thanks for your reply. I have a few points to make-

Hi Ambitious

I'm not an expert in Net Premium Valuation but I took it to come from the fact that the net premium is calculated based on the valuation assumptions including the valuation rate of interest. The net premium reserves remain fairly stable because any increase/decrease in the value of the benefits and expenses is offset by an opposite change in the net premium.

Investing short will give the liabilities a lower discounted meant term and so more stable values. You can estimate the change in your liabilities from an absolute change in the valuation interest rate from discounted meant term * change in valuation rate * market value. For example, liabilites of £100m with a 5-year discounted mean term will change by £5m if the valuation rate increases by 1%.

How can you affect the DMT of the liabilities by investing short? What you actually invest are your assets and if you invest your assets short, the DMT of assets will reduce. The liabilities will still have a high DMT as the liabilities are fixed obligations. I think that this is a big mismatch even if you base your valuation rate of interest on actual asset holdings!
You have given a good example of change in the liabilities, however the change is likely to be different from £5M as there is generally a convexity effect but thats a separate issue


I guess that assets and liabilites are more strongly correlated from the net premium valuation method because you use the same interest rate.
I agree this point and as you'd mentioned earlier, this reason makes the NPV reserving method less sensitive to the change in the basis.

Hope this helps

 

[b_colgan]

Whoops! Yes, you invest the assets not the liabilities. Investing the assets short means their value would change less than the liabilities'.

The "DMT * shock * value" is a first-order approximation. There would also be an affect from convexity, as you've already said.