What is replicating portfolios?

So, what is replicating portfolios? Topic – IFRS 17 Insurance contracts. A replicating portfolio is a pool of assets designed to reproduce (replicate) the cash flows or market values of a pool of liabilities across a large number of stochastic scenarios used among other in the insurance industry. Once set up, a replicating portfolio can be used to predict the behavior or change in value of the liabilities across a range of other economic conditions. What is replicating portfolios

Definition of replicating portfolios

A replicating portfolio is a proxy portfolio consisting of standard capital-market products that replicate the scenario-dependent payoffs of the insurance company’s liability. It is determined across a wide selection of calibration scenarios by optimisation techniques. Because this replicating portfolio is composed of capital-market products, the valuation of liabilities is consistent with the valuation of the asset side of the balance sheet. Assets could include real assets on the market, imaginary assets, simple liabilities, or indeed any mathematical function.

Developed by the banking industry, the replicating portfolio technique has been used for several years. The great benefit of replicating portfolios lies in the speed of recalculating the effects of financial market developments. Banking asset-data systems have the ability to recalculate the value of assets in real time, often because closed-form solutions are available for determining asset market values. By using these systems, insurance companies have the ability to monitor and manage the financial risks at a much greater frequency.

How the financial industry uses replicating portfolios

The concept of replicating portfolios serves a number of purposes. Broadly, there are two main applications of the replicating portfolio technique:

  1. Economic-capital calculations. Because of their stochastic nature, economic-capital calculations require significant calculation power. The replicating portfolio as representation of insurance liabilities significantly reduces the run times for estimating the impact of economic changes on the value of the liability portfolio.
  2. Hedging and management of financial risks. What is replicating portfolios
  3. Other applications of the replicating portfolio are in the areas of financial-risk management and financial reporting. All these applications are described in more depth in the following sections.

Objectives and Caveats and Limitations

OBJECTIVES What is replicating portfolios?

CAVEATS AND LIMITATIONS What is replicating portfolios?

Replicating portfolios can reduce run time for the projection of liability cash-flow proxies and for liability valuations. What is replicating portfolios?

Replicating portfolios are not applicable to the measurement of non-financial risk, such as insurance risk. What is replicating portfolios

Replicating portfolios facilitate sophisticated risk aggregation.

Determination of replicating portfolios requires a significant number of calibration scenarios, specific knowledge about universal assets, and a robust optimisation tool.

Replicating portfolios enable separation of investment and insurance business for management purposes. What is replicating portfolios? What is replicating portfolios?

There may not be actual assets or actively traded assets that replicate long-term or exotic features of insurance liabilities. What is replicating portfolios

Economic-capital calculations IFRS 17 Insurance contracts Contents

In recent years, regulators and rating agencies have turned to monitoring financial institutions using Value at Risk (VaR) and Tail Risk (TVaR) criteria. This focus has led to the development of internal economic-capital models within the financial industry. The introduction of Solvency II has brought with it a need for insurance companies to develop more stable, accurate, and auditable frameworks. What is replicating portfolios

Portfolio replication has become an important method for many insurance companies in the building of this next generation of economic-capital models.

Replicating portfolios allow insurance companies to create an integrated view of assets and liabilities that can be used to perform a detailed analysis of asset-liability management (ALM) risks.

Aggregation of non-market risks such as credit risk, operational risk, and mortality risk can be achieved using the more traditional correlation matrices or the more advanced copula approach.

The main motivation for the use of replicating portfolios is speed. Insurance companies want to compute economic-capital figures quickly and accurately to use them in their business decision making, and portfolio replication offers one option for improving the speed of economic-capital calculations.

Financial risk management/hedging

Investment and insurance-operation balance sheets

In the banking industry, it is common practice to separate the balance sheet into a trading book and a banking book in order to separately measure the performance of banking and investment operations. The trading book within a bank is made up of all operations from the trading room business. The banking book of a bank is the sum of all the banking operations: loans to individuals, loans to corporations, deposits, etc.

This banking industry methodology can also be used within the insurance industry by replacing the banking book with an insurance book. The insurance company balance sheet can be split between investment operations and insurance operations. The replicating portfolio represents the insurance liabilities and transfers the financial risk from the insurance operations balance sheet to the investment operations balance sheet. Any residual financial risk on the balance sheet of the insurance operations results from imperfect replication. The ‘real’ assets and the related financial risks are managed in the investment operation. Generally, the economic net worth of the company is managed by an investment company. For this purpose, an ex-ante financial-risk budget—included in the risk appetite of the company—is established.

Hedging

Within this framework the replicating portfolio can be used for daily monitoring of the market risk between the liabilities and the assets backing the liabilities. By using a live feed of financial market information, common measures such as delta, vega, gamma, and rho can be monitored.

Another benefit of the separated insurance and trading-book framework is that the daily performance analysis can be split by type of financial risk, such as:

  • non-market risks
  • hedging risk
  • non-hedgeable market risk
  • strategic/tactical market risk

This type of financial risk measurement splits asset management into two types of asset management: hedging asset management and risk/return asset management.

The main focus of hedging asset management is on hedgeable market risk. This report will focus on a full financial de-risking of the liabilities under management. The replicating portfolio becomes the target portfolio. However, the theoretical replicating portfolio is not always practical because of the non-hedgeable market risk—for example, the extremely long-term interest-rate risk of some insurance liabilities.

Risk/return asset management focuses on strategic and tactical market exposures. This department targets financial opportunities within the markets. Risk/return asset management opens risk exposures based specifically on financial opportunities.

Replicating portfolios are also used for other purposes, including dynamic hedging and management of market risk. One other technique that has emerged is cluster modelling. Cluster modelling involves using a subset of the liabilities, with an appropriate scalar applied to each cell to represent the entire liability portfolio.

What is replicating portfolios?

What is replicating portfolios

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