Asset Liability Management

January 6, 2014

Asset Liability Management

The practice of managing a business so that decisions on assets and liabilities are coordinated
Ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints An insightful view of ALM is that it simply combines portfolio management techniques (that is, asset, liability and spread management) into a coordinated process. Thus, the central theme of ALM is the coordinated management of the entire balance sheet.

Asset Liability Management

ALM focuses on 3 major risks. Interest Rate Risk, Liquidity Risk and Credit Risk.
Interest Rate risk depends on the circumstances of the particular investor. Banks concerned with ST. Focus on protecting current net worth against interest rate fluctuations Insurance and Pensions concerned with LT. Focus on protecting future value of the portfolio

Asset Liability Management

Core of ALM Assume prudent levels of risk Price the risk properly in charging for its products Manage the risk successfully
Focus of ALM Coordinate investment strategy with product design pricing and inforce management Difficulty arises from the complex interrelationships among long term (life contingent liabilities) and asset classes PV of CFs depend on the interest rates used Amount and timing of the CFs cannot be predicted with certainty due to the contingent events

Key elements contributing to investment risk LT nature of most products (insurance companies in particular) Guarantee benefits Early withdrawal provisions

Major Asset classes in portfolio of financial institutions

Bonds Issuer can retire the bond earlier when market rate falls below the rate on the bond Bond holder would be forced to reinvest at reduced interest rates

Mortgages Include prepayment provisions can pay down principal earlier Influenced by interest rate movements

Major Asset classes in portfolio of financial institutions

Stock Historically produce higher returns in the long run
No predictable CFs and high volatility in its price - not suited to back long term guaranteed liabilities

Two measures of CFs

Value depend on the timing, amount and certainty of the future CFs and on the time value of money
Return consist of the generated CFs and the change in its value

Managements objective
Increase surplus by producing returns on assets in excess of returns promised on liabilities
Unpredictability of returns due to changes in capital market variables leads to investment risk

Requirements for investment returns

If the assets fail to return the guaranteed minimum rate the insurer will suffer a loss Insurer/fund manager/bank must credit rates competitive enough to maintain market credibility
Returns must cover general operating expenses and provide insurer with profit margin

Requirements for investment values

If the MV of the assets backing an accumulation type product/policy is less than the withdrawal value available to the customer the insurance company/fund manager/bank will suffer a loss on withdrawal The liability value doesnt fluctuate with interest rates like the assets supporting them do

Interest Rate Risk

Maturity Mismatch Risk A mismatch in the A&L maturities Reinvestment risk occurs when liability CFs are longer than asset CFs- Loss occurs if assets are reinvested at lower than expected interest rates Disinvestment risk occurs when liability CFs are shorter than asset CFs Potential loss from liquidating depressed assets at the higher-than-expected-interest-rates environment

Interest Rate Risk

Option Risk Assets contain call or prepayment options (the rights to prematurely retire debt at a fixed value) Liabilities contain put options (the insureds right to surrender a policy and receive its cash value) Potential cost of these options increase when interest rates change In times of low (high) rates, options accelerate (decelerate) cash inflows and increase (decrease) funds to be invested at unfavorable (favorable) rates

Annuities
Annuity Contract providing regular payments to the contract holder (annuitant) for a specified period or for the annuitants life
Variable annuity Contract holder buys the policy with a single premium Proceeds allocated among a selection of funds underlying the contract

Types of Variable Annuities

GMDB GMIB GMAB GMWB

Guaranteed Minimum Death Benefit

Death Benefit = Max (G, AV) G guarantee. It is reset every few years and G(t) = Max(G(t-1),AV)
If fund performs strongly, the GMDB will increase significantly over time

Variable Annuity Basics

Variable Annuity Basics Account value in a variable annuity varies with the investment performance of a separate account (SA) SA is a segregated pool of assets legally district from the insurers general account It is divided into sub-accounts that pursue distinct investment objectives Policyholders allocate their premiums among those sub-accounts and free to re-allocate the balances among them Growth of AVs depends on the performances of subaccounts, reduced by asset charges & policy loads

VA Risk
The living benefit guarantees and PH behaviour increase insurers risk
PH Behaviour Options to lapse Shifting underlying asset mix

Two Reasons Why ALM is Needed for VA

Reduce Revenue Risk Revenues from VA are based on policy charges (M&E fees) and surrender charges Both charges are account-value-based - Revenues vary directly with the level of the equity market

But the general administrative costs do not vary with the equity market

A sustained downturn in the equity market will squeeze profits unless an insurers cost structure can be quickly adjusted

Two Reasons Why ALM is Needed for VA

Minimize Benefit Risk - Intended to protect policyholders against equity market declines under certain contingencies - GMDB: Paid GMDB if account value < GMDB due to poor investment performance - GMAB: Guarantee certain values during the accumulation phase - GMIB: Guarantee certain values during the annuitization phase

Reasons Why VA Guaranteed Benefits are More Significant Than Expected

Pricing analyses may be flawed due to an overly simplistic depiction of capital market dynamics Guaranteed benefit provisions in new product offerings are more liberalized due to competition While the frequency of claims is expected to be small, claim amounts can be enormous

Challenges in ALM
Measurement Basis Economic Value In asset side, economic value is its market value (the value can be immediately realized) In liability side, economic value is its fair value (calculate in a way consistent with valuing its assets)

Challenges in ALM
Economic Analysis of A&Ls is Complicated Characteristics of the assets and liabilities Capital market uncertainties involved Long-range time horizon
Steps to Perform Economic Analysis Specify the CF pattern (timing and amounts) Model the capital market variables (that affects CF pattern) and the sensitivity of the instruments CFs to those variable determined Model the insurance contracts and the actual assets and aggregate the results Perform a large numbers of economic scenarios to quantify the effect of the economic sensitivities

Challenges in ALM
Communication Proper communication of ALM exposures, strategies and outcomes to company management and other interested parties (e.g. regulators and rating agencies) Effort and resources will be more easily obtained if all parties understand the importance of ALM ALM also requires cooperation between the actuarial and investment areas
Difficult to Achieve Consensus Threats posed by investment risk may not be readily apparent to all Indicated risk mitigation actions may involve complex techniques and concepts Few experienced practitioners in the market

Approaches to ALM
Investment Strategy Take the inforce liability structure as given and aim to manage investment risk by a complementary investment strategy Demand a thorough understanding of the dynamics of both A&Ls Standard asset types (bonds and mortgages) and nonstandard asset types (derivative) can be used to offset the risk dynamics of the liabilities
Product Design Proper coordination of product design with investment strategy must be considered in ALM

Approaches to ALM
Traditional insurance risks are non-systematic Fluctuations in experience are random and average out over larger populations Investment risk is systematic All insured risks are strongly affected by certain variables Pooling investment risk will concentrate the exposure (instead of diversifying it)
Securitization Sell a stream of contingent revenues to another party at a discount to the expected value

Approaches to ALM
Holism Focus on risk at the enterprise level (rather than at the product or line-of-business level (LOB)) Seek to identify and exploit existing or potential synergies in a companys diverse business activities o e.g. sell life insurance and annuity business to diversify mortality risk
Two Consequences of Analyzing LOBs Separately Aggregated investment risk will likely be overstated Insurer will either incur unnecessary reparative costs or forego potential profits

Approaches to ALM
Benefits of Holism Evaluate total-company risk on an integrated basis to show the synergy benefits among different LOBs
Free up the cost of managing the risk Enable company to assume more risk Design complementary products to enhance overall risk reduction effects Review ALM implications of strategic initiatives to guide better strategic decision-making

Immunization
A strategy employed to ensure that a change in interest rates will not affect the value of a portfolio
Methods Cash flow matching Duration matching Convexity matching

Cash flow matching

Conceptually the easiest form of immunization Match the liabilities with assets whose CFs are identical
Advantage Theoretically eliminate the interest rate risk Disadvantages Uncertainty of CFs: Exercising embedded options and changes in exogenous factors (e.g. mortality rates) alter the CF pattern Matching Reduces Flexibility: Matching the CFs can force insurers to accept lower bond yields No Pain, No Gain: Insurers can sometimes take a mismatch position in order to earn a fair return

Duration
A measure of the first-order interest rate sensitivity of a financial instrument Quantify the effect on MV of a one-percentagepoint change in interest rates
e.g. 1% increase in interest rate 4% decrease in MV of a bond if Duration of the bond = 4

Can be calculated from the projected CFs of the financial instrument

Duration Matching
Eliminate interest rate risk immunize its surplus against adverse fluctuations by matching its A&Ls A difficulty arises because the duration changes both as time passes and as interest rates change
Immunization requires constant monitoring of the durations of A&Ls and rebalancing the asset portfolio to match its liabilities

Duration Matching
Segmentation Establish separate asset portfolios for LOBs with different duration values Assets of the segment can be managed in a manner appropriate to the liabilities Limitations of Duration
Duration cannot accurately predict the changes in value for a large change in interest rates Because duration changes as interest rate changes Duration assumes a parallel shift in yield curves In reality, yield curves shift in non-parallel fashion Duration does not consider the uncertainty of the CFs It does not capture the effects of calls and prepayments in assets and premature surrenders in liabilities

Refinements to Duration
Convexity A measure of the second-order interest rate sensitivity of a financial instrument The sensitivity of duration to changes in interest rates Insurer can protect against a wider range of interest rate movements by matching convexity and duration
Key Rate Durations Address the issue of non-parallel shifts in the yield curve Reflect the interest sensitivity of an instrument to the change in corresponding terms on the yield curve All key rate durations of A&Ls must be matched to protect surplus against non-parallel shifts in the yield curve

The Regulator and Rating Agency Perspective on ALM

Regulation of Insurer Investment Adequacy Restrict the proportions of total assets that can be held in various investment grades and the concentrations in the assets of a single issuer
Regulation of Insurer Asset Adequacy Companies must understand the interest rate sensitivities and relationships of A&Ls Failure to do so results in the establishment of penalty reserves Practice of cash flow testing (CFT) as a tool for assessing the adequacy of assets backing liabilities

The Regulator and Rating Agency Perspective on ALM

Regulation of Insurer Capital Adequacy Minimum capital levels to be held Regulator describes the nature and extent of regulatory intervention that may be required depending on the relationship between actual capital levels and those specified by RBC Regulation of Insurer Liquidity Focuses on insurers stress liquidity management practices through an interrogatory process and by encouraging the creation of a liquidity plan

Rating Agencies
Evaluate insurers A&Ls, capital adequacy and business plans and strategies Act as another line of protection for policyholders and investors Issue letter-ratings of insurers claims-paying and debt repayment abilities Request copies of CFT reports and any supplementary ALM studies

Best Practice in ALM

Secure Senior Management Commitment Senior management must understand the important linkages between ALM and both the companys near term financial results and its long-term viability
Ensure a Clear Assignment of Roles and Responsibilities Each team member must recognize his/her importance to the process and its overall risk management objectives

Best Practice in ALM

Leverage the Cash Flow Testing Platform Cash flow testing platform for regulatory purpose can be tailored to be a modeling system to produce the ALM metrics most relevant to the companys management practices and business objectives
Ensure a Responsive and Effective Mitigation Process Effective ALM implementation should lead from the quantification step to the mitigation step

Future Challenges and Opportunities

Globalization Increase the need for a holistic view of ALM Acquisition of foreign operations should not be undertaken without a thorough understanding of the consolidated risk position (e.g. differences in product types and asset classes, profit repatriation and current exchange risks) Fair Value Accounting Further the convergence of ALM and financial reporting Facilitate the application of ALM to management and shareholder objectives