Asset/Liability Management Models in Insurance and Benchmark Decomposition

Asset/Liability Management
Models in Insurance and

Benchmark Decomposition
Alexei A. Gaivoronski and Sergiy Krylov
Norwegian University of Science and

Technology
Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 1

June 2001 Corso di dottorato di ricerca
Contents
1. Introduction: ALM model outline
2. Approximations:
scenario trees
parametric strategies
3. Benchmark decomposition
4. Modern risk measures: VaR
5. Solution techniques
6. Architecture of software system
for ALM

Literature
• D.R. Carino and W. Ziemba (1998)
• G. Consigli and M.A.H. Dempster (1998)
• A. Consiglio, F. Cocco and S. Zenios (2000)
• J. Dupacova, M. Bertocchi and V. Moriggia (1998)
• A. A. Gaivoronski and Petter de Lange (1999)
• K. Hoyland and S. Wallace (1998)
• P. Klaassen (1998)
• H. Mausser and D. Rosen (1998)
• J. Mulvey and H. Vladimirou (1992)
• G. Pflug and A. Swietanowski (1998)
• S. Zenios, M. Holmer, R. McKendall and C.
Vassiadou-Zeniou (1998)
• W. Ziemba and J. Mulvey (eds.), Worldwide Asset
and Liability Management, Cambridge Univ. Press,
1998

Asset/liability management
Determine a portfolio investment strategy
over time in order to meet a sequence
of liability payments in the future
Insurance company
• maximize expected utility of wealth or related

objective function
• maintain competitiveness
• maintain adequate reserves and cash levels
• meet regulatory requirements

Motivation
• Increased interest for adequate risk
management from the part of industry
• Integrated ALM models are a challenge
– dynamics and uncertainty
– complex intertvined structure of
assets/liabilities/regulatory requirement
• Approximations to reality are inevitable
– modeling tradeoffs between decision
flexibility and representation of uncertainty
• Two main approximation approaches:
– scenario trees
– parametric strategies

Scenario tree
t=0
t=1
t=2
Each node:
• values of risk factors
• decisions
Huge amount of nodes:
binomial tree with 10 random quantities
each additional time period multiplies
the number of nodes by 1000
Scenario trees
• Some important theoretical studies and
applications
• Allow rich decision structure
But
• Require complex scenario generation
procedures which
– reflect dynamics of prices
– are sound from the point of view of financial
theory
– affordable numerically
Pflug & Swietanowski (1998),
Hoyland & Wallace (1998)
• Require solution of huge convex
optimization problem
Example: 10 assets, one year horizon, one
month time step: 1036 nodes
Scenario trees
• easy to represent “mainstream” events,

difficult to represent events of relatively
small probability
• consequently, difficult to meaningfully
utilize modern risk measures like
Value-at-Risk
t=0
t=1

Parametrization
• select a class of strategies which
represent asset and liability management
decision as a function of state which
depends on relatively small set of
parameters
• optimize the system performance with
respect to these parameters
Example: fix mix strategy: parameters - fraction of
total asset value invested in a given asset
Scenario optimization
• Allows much richer and more adequate
representation of dynamics of risk factors
• Allows consideration of small probability
events and, consequently, VaR

Parametrization
• optimization problem is of relatively
small size
But
• decision set is relatively restricted
• how to elect good family of strategies is
far from clear
• optimization problem is not convex and
may have local minima
• estimation of performance necessary for
optimization may be time consuming
Tradeoff between adequate

representation of uncertainty and
richness of decision set

Combined approach
t=0
t=1
t=2
• scenario tree with decisions on nodes

for the first few periods
• parametric strategies on later periods
A.A.Gaivoronski & P. de Lange (1999)
Benchmark decomposition
• Objectives:
– reduce the size of the model and yet
preserve expressive power
– Permit straightforward utilization of
modern risk management approaches, like
VaR
• Method: substitute the original large
model with sequence of smaller models
• Approach
– select benchmark wealth growth process
– choose asset portfolio from
performance/risk tradeoff relative to
benchmark
– optimize liability part with respect to
remaining decisions and performance/risk
tradeoff

Top level view of modeling
process
• Liability management
• Debt/equity structure
• Regulatory constraints
• Integrated ALM performance
• benchmark
• relative performance/risk tradeoff
• Selection of portfolio of assets

• Portfolio risk management

Model structure
• Benchmark
– market index
– wealth growth process
– liability growth for products with
guarantees
• ALM Model components
– liability process
– portfolio rebalancing
– cash flow
– debts
– equity
– regulatory constraints
– performance objective
– decisions

ALM Model
• Notations:
t  1, . . . , T time
i  1, . . . , I assets
j  1, . . . , J liabilities
k  1, . . . , K cash inflows
l  1, . . . , L debts
• Portfolio rebalancing
t
xi portfoli
o
r ti relative return
xti bought assets
t
x i sold assets
x ti 1  1  r ti x ti  x ti 1  x ti 1

x t
i
1
 1  r t
i x t
i
ALM Model, continued
• Cash flow
c i buying transaction costs
c i selling transaction costs
t
di dividends
ytj cash to service liabilities
z tk external cash inflow

t
vl current debts
v tl newly acquired debts
t
v l repaid debts
w tl debt servicing
I I K L
 1  ci xti   d ti xti   z tk   vtl 
i 1 i 1 k 1 l 1
I J L L
 1  ci xti   ytj   w tl vtl   vtl
i 1 j 1 l 1 l 1
• Debts
t 1 t t t
vl  vl  vl  vl
• Equity
• Regulatory constraints
– portions of assets
I
x tm  b m  x ti , m  M
i 1
– cash reserves
t t
x1  C
– debt restrictions
L
 vtl  V t
l 1
– assets/liabilities ratio
I L T J
 xti   vtl  eE   b , tyj
i 1 l 1   1 j 1
• Performance measure
I L J
maxx t ,x t ,v t ,v t E  xTi   vTl   yTj
i i l l
i 1 l 1 j 1
• random quantities
t  r ti , ytj , z tk , w tl , d ti , C t , b , t
 t   1, . . . ,  t
• decisions
t t t t
xi , x i , v l , v l
• state variables
u t  x t , vt 
• strategies
t t t t
xi  , xi  , vl  , vl  t 1
t 1 t 1 t 1

Parametric strategies
• Parameters
n
a  A R
• Parametrization
xti   ti a,  t , u t , xti   ti a,  t , u t ,
vti   tl a,  t , u t , vti   tl a,  t , u t 
• Problem I L J
maxa A E  xTi   vTl   yTj
i 1 l 1 j 1
x ti 1  1  r ti x ti
    t 1
i a
t 1
i a
 ti 1 a  1  r ti x ti
v tl 1  v tl   tl a   tl a
I I K L
 1  ci  ti a   d ti xti   ztk    tl a
i 1 i 1 k 1 l 1
I J L L
  1  c i  ti a   ytj   w tl vtl    tl a
i 1 j 1 l 1 l 1
Fix mix strategy
• LP to be solved for each time period
I L
min t
i ,
t t t
i , l , l
 ci  ti  ci  ti     tl   tl 
i 1 l 1
1  r tq xti   ti 1   ti 1 
I I I
a xi  1  r tq x tq    tq1    tq1
q 1 q 1 q 1
 ti 1  1  r ti xti
L L L
vtl   t
l   t
l  a vl  vtq    t
q    t
q
q 1 q 1 q 1
I I K L
 1  c i  ti   d ti xti   ztk    tl
i 1 i 1 k 1 l 1
I J L L
  1  c i  ti   y tj   w tl v tl    t
l
i 1 j 1 l 1 l 1

Benchmark decomposition
• Benchmark Rt
R t  1  R t
R t 1
Qt  Rt
I
 1 r ti x ti
x ti
t
P  i 1 a xi  I
I
 x ti  x tq
i 1 q 1
• Portfolio optimization problem
mina  A Ha , Q
x x
x
I
  i a xi  EQ  
i 1
I
 a xi  1, a xi  0
i 1
Risk measures
• Relative regret
I
Ha x , Q  max 0, Q   r i a xi
i 1
• Value at Risk
I
sup V | P  r i a xi  Q  V  1 
i 1
• Conditional VaR
I I
E  r i a xi |  r i a xi  Q  V
i 1 i 1
Uryasev & Rockafellar (1999)

General picture
MATLAB
File
Modeler
Data
90
80
70
60
50 East
40 West
30 North
20
10
0
Excel,...
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
LP-solver
NLP solver
XPRESS(XBSL)

Summary
• asset/liability management by stochastic

optimization of simulation model
• curse of dimensionality is beatable by
consideration of parametrized policies
• alternative risk measures like VaR can
be incorporated in the model
• customization of modern nonlinear
optimization tools allow solution of
advanced models


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Asset/Liability Management

Models in Insurance and

Alexei A. Gaivoronski and Sergiy Krylov

Norwegian University of Science and

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 1

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 2

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 3

• maximize expected utility of wealth or related

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 4

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 5

• easy to represent “mainstream” events,

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 8

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 9

Tradeoff between adequate

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 10

• scenario tree with decisions on nodes

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 12

• Selection of portfolio of assets

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 13

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 14

x ti 1  1  r ti x ti  x ti 1  x ti 1

z tk external cash inflow

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 18

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 20

Uryasev & Rockafellar (1999)

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 22

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 23

• asset/liability management by stochastic

Alexei.Gaivoronski@iot.ntnu.no Universita’ degli Studi di Bergamo 24

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