Replicating portfolios

In recent years, many insurers have adopted increasingly complex stochastic models as part of their business-management processes. Traditional actuarial models can typically be developed to support much of this analysis. However, the complexity of these models makes it difficult to link them into a real-time financial reporting process. Consequently, a number of techniques have been developed to make such processes more practical. One such technique is the use of replicating portfolios.

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. 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. A number of large European insurers have adopted replicating portfolios as part of their regular modelling and financial reporting process. In addition, we are seeing increased interest in several other jurisdictions, particularly in Asia.

For a number of reasons, replicating portfolios may enhance the value of traditional actuarial modelling. However, there are also limitations with this approach. The wise modeller would be well advised to understand these limitations in order to reduce the risk of using the technique inappropriately, which may result in misguided and inaccurate management action.