Immunization

Extract

This subject can appear difficult, but the main idea is delightfully simple. Let us consider an example. Suppose that a life office has issued policies at premiums based on a certain rate of interest, investing in Stock Exchange securities the premiums received from year to year, less claims, and that after a time the rate of interest rises permanently. The market value of the investments will fall and the office will lose if they have eventually to be sold, but will gain to the extent that future premiums can now be invested on more favourable terms. The gain is fixed but the loss will vary according to the redemption dates of the assets, since the longer the date, the greater the fall in value. Immunization consists in selecting investments such that the loss balances the gain. An alternative way of looking at it is on the basis of present values. The values of the assets on the one side of the balance sheet, and the net liabilities on the other, will both fall if interest rates rise. We want them to fall by the same amount, and as our liabilities are fixed, we must seek to achieve that result by a suitable choice of assets.