Valuing and Hedging Complex LPI Liabilities
Document ID: 2006-750 (previously 2006/007)
Published on: 31st August 2006
Author: Craig Turnbull
LPI pension liabilities can be complex and the inflation optionality embedded in them can be difficult to value. This is particularly true when considering deferred liabilities with LPI indexation both pre- and post-retirement. The B&H Annuity Model (in conjunction with the Economic Scenario Generator which is an integrated part of the software) can be used to accurately value such liabilities. The model has the functionality to explicitly model the cashflow behaviour of such liabilities, and to simultaneously model any number of deferred liability tranches with different cumulative pre-retirement LPI accruals. This valuation capability can be a powerful tool in hedging such liabilities. It is very difficult to find exact cashflow-matching strategies for liabilities with LPI indexation in deferment. By re-calculating lliability values in different interest rate / inflation sensitivity test environments, we can establish the greeks of the LPI liability (at the policy or portfolio level), and hence determine the appropriate composition of a hedge portfolio of nominal and index-linked assets.
