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Portfolio Choice Models of Pension Funds and Life
Assurance Companies: Similarities and Differences

Presented at "The Role of Insurance in the Modern Economy
Conference, organized jointly by the Association of Italian
Insurers (ANIA) and Centro Europa Richerche, Rome (CER)
and held at Venice, Centro Zitelle, Giudecca, 7-8 October 1996.

David Blake


Pension funds and life assurance companies are the principal long term
investing institutitons and as such they will have liabilities of the longest
duration. These liabilities will also be similar in nature, although there will
be qualitative differences, e.g., life policies provide for such features as
policy loan, and early surrender options in a way that pension funds do not,
and defined benefit schemes have options on the invested asssets in a way
that life policies do not. The greatest systematic risk faced by both sets of
institutions arises from any mismatch of maturities between assets and liabilities.
To minimise the risks associated with maturity mismatching, the two sets of
institutions will tend to hold a substantial proportion of long term assets, such
as equities, property and long-term bonds, in their portfolios; although, given the
specific nature of the options attached to life policies, life companies will hold
a relatively larger proportion of more capital-certain assets, such as bonds,
in their portfolios than pension funds.

In this paper, we examine pension schemes and life policies in terms of the
option features either implicitly or explicitly contained in them. We argue that
this greatly simplifies the process of managing the asset side of pension fund
and life company balance sheets. We show that these options need to be either
replicated or hedged with an appropriately determined of cash market and
derivative securities. The natural portfolio choice framework for achieving this
is asset-liability or surplus risk management. We use this framework to derive
a dynamic asset allocation strategy over the lifetime of a pension scheme
which involves switching, according to pre-set criteria, between equities,
index bonds and conventional bonds. We also use this framework to derive
a procedure for hedging the risk faced by life companies from the exercise of
the options embodied in their products. We end the paper with an example that
applies our dynamic asset allocation strategy to the case of a defined benefit
pension scheme.

Key words: life assurance companies, pension schemes and funds,
assets and liabilities, duration, fund management, asset allocation,