The key objective for a life insurer, pension scheme or asset manager is to ensure there is sufficient cash flow to fund future payment obligations to clients. However, achieving this goal in a low-rate environment with increasing regulatory oversight and capital requirements is becoming ever more challenging. As a result, many insurance and pension providers are turning to LDI strategies to more readily attain their funding target.
An LDI approach should ideally be twofold. It should include an offensive strategy with higher yield and total return investments to help generate an appropriate return. To balance this out, firms should have a defensive approach to risk management. This includes investments and derivative overlays based on systematic factors such as interest rates and inflation, which help accurately manage liability risk. Interest rates and inflation are volatile, and when either moves, the entire solvency position can change drastically. LDI allows you to prevent a funding deficit from worsening because of macroeconomic instability, interest rate volatility and inflation risk.
Risk analysis is the foundation of an effective LDI program as it helps gain visibility on the downside of the different investment strategies. A key element of the analysis is the evaluation of various risk factors that influence a portfolio’s funded status and how they affect the ability to meet the ongoing payment of liabilities. These risk factors have significant influence on a firm’s investment strategy, hedging and rebalancing decisions.
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