SFRA Knowledge Transfer Workshop - Professor Antoon Pelsser

Replicating Portfolios: Theory and Application

This workshop was held in Edinburgh on 29 November 2011

Workshop Overview

Portfolio Replication methods have become increasingly important as risk management tools for insurance companies. The method of Replicating Portfolios allows insurance companies to calculate quickly and accurately the financial risks of (complete portfolios of) insurance liabilities. By mapping the existing liabilities onto Replicating Portfolios of traded financial instruments, significant improvements in speed and accuracy can be obtained compared to traditional methods such as model points or full Monte-Carlo simulation of the insurance liabilities.

Workshop Programme

• Basic Idea of Replicating Portfolios (1 hour)
  
• - Replicating portfolio for an insurance company
  - Theoretical justification for replicating portfolio
  - Calculation of replicating portfolio
  - Types of economic scenarios used? Risk Neutral, Real World, Stress Test, Historical, Other
  - How many scenarios?
  - How do you capture the tails? High volatility scenarios, stress test scenarios, other?
  

• Calculating Replicating Portfolios (1 hour)
  
• - Cash Flow bucketing: low/high bucketing; what do you gain/lose?
  - Intuition: why 'low bucketing' is a good thing (contrary to the actuary's intuition!)
  - Alternative objective functions
  - Value constraint
  - Trade penalties
  - Other important constraints
  

• Hands-on Session (1.5 hours)
  
• - Replication of pure Cash Flow instrument with Discount Bonds
  - Replication of Profit-Sharing with Swaptions
  - Replication of Unit-linked with Equity-options
  

• Evaluating the Results of a Portfolio Replication (1 hour)
  
• - How to select good replicating instruments
  - What are the best metrics? R-squared, sensitivities, PV01
  - What is acceptable error? How do we measure the error?
  - Matching the variance
  - Matching the terminal value
  - Matching "local" sensitivities vs. "big shock sensitivities"
  - Adding constraints to "improve" the replicating portfolio
  

• Using a Replicating Portfolio for Economic Capital (1 hour)
  
• - How do we assess the error in our EC calculation?
  - How do we determine the source of any errors?
  - Determining the inverse lookup function for each marginal risk distribution
  

Hands-on Session (1 hour)

• - Example calculation of EC for insurance portfolio
  

About The Workshop Leader

ANTOON PELSSER is the author of "Efficient Methods for Valuing Interest Rate Derivatives" (Springer Verlag, 2000).

Antoon is Professor of Finance and Actuarial Science at Maastricht University and a research fellow at Netspar. His research interests focus on pricing models for interest rate derivatives, the pricing of insurance contracts and Asset-Liability Management (ALM) for insurance companies. Antoon has previously held positions as Erasmus University in Rotterdam and the University of Amsterdam. He has published in leading academic journals including Mathematical Finance, Finance and Stochastics, Journal of Derivatives, and Insurance: Mathematics and Economics. He is on the editorial board of ASTIN Bulletin and the International Journal of Theoretical and Applied Finance. He is an Honorary Fellow of the Institute of Actuaries.

In addition to his academic career, Antoon has extensive professional experience in the financial services industry. From 2004 to 2007, he worked at ING Group's staff department Corporate Insurance Risk Management, where he was involved in implementing a new internal model for measuring Economic Capital for ING-Insurance. From 2000 until 2004, he was Head of ALM for Nationale-Nederlanden. Prior to that, Antoon worked for 7 years in the dealing-room of ABN-Amro Bank in Amsterdam, where he was responsible for the development of pricing models for derivatives.

Link to Antoon Pelsser's publications and Antoon's homepage.

Terms and Conditions of Workshop

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