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 .

not suited to back long term guaranteed liabilities .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 .

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 .Two measures of CFs • Value – depend on the timing.

Management’s 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 doesn’t fluctuate with interest rates like the assets supporting them do .

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 Maturity Mismatch Risk • A mismatch in the A&L maturities • Reinvestment risk occurs when liability CFs are longer than asset CFs.

options accelerate (decelerate) cash inflows and increase (decrease) funds to be invested at unfavorable (favorable) rates .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 insured’s 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.

Annuities Annuity • Contract providing regular payments to the contract holder (annuitant) for a specified period or for the annuitant’s 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 .

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


reduced by asset charges & policy loads .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 insurer’s 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.

VA Risk • The living benefit guarantees and PH behaviour increase insurer’s risk PH Behaviour • Options to lapse • Shifting underlying asset mix .

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 insurer’s cost structure can be quickly adjusted .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 .

GMDB: Paid GMDB if account value < GMDB due to poor investment performance .Intended to protect policyholders against equity market declines under certain contingencies .Two Reasons Why ALM is Needed for VA Minimize Benefit Risk .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 .

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

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 instrument’s 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 .

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 .Challenges in ALM Communication • Proper communication of ALM exposures. strategies and outcomes to company management and other interested parties (e.g.

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 .

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 .g.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 company’s diverse business activities • o e.

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. 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 .g.

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 • 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.

Duration Matching • Eliminate interest rate risk immunize its surplus against adverse fluctuations by matching it’s 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 .

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 .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.

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 insurer’s stress liquidity management practices through an interrogatory process and by encouraging the creation of a liquidity plan .

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 .Rating Agencies • Evaluate insurers’ A&Ls.

Best Practice in ALM Secure Senior Management Commitment • Senior management must understand the important linkages between ALM and both the company’s 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 company’s 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. 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 . differences in product types and asset classes.

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