Stochastic Asset Liability

Modelling
Working Party

Members : Chairman John Ryan

RichardBulmer
Patrick
Byrne
StewartCoutts
Julian
Lowe
GaryWells

1995 General
Insurance Convention

1
 StochasticAsset Liability
Modelling
Working Party

Pressures
ofworkmeantthattheWorkingPartymetonlya limited
number oftimes and
mappedouta workprogramme anddiscussed somekeyissues.Itwasfeltthat inthe
timescale
available
itwas notpossibletocomplete all
theworkrequired and that
therefore
this
will
needtobecontinued
insubsequent years.
This
reportistherefore very
mucha preliminary
onetooutline
somekeyissues andtoprovide
a basisfordiscussion
for
theprofession
goingforward.
Inparticular,
the Working
Party
would find
itvery helpful
for
comments tobemadeonthetopics considered.

Terms of Reference

TheWorking
Party
took
thefollowing
asits
terms
of reference.
1 To review
thecurrent
state
oftheartinasset
liability
modelling
including
currencies
andalsotheuseofhybrid
contracts
suchasinsurance
options,
2 Toclarify
theobjectives
ofsuch
work.
3 Toundertake
/document
research
as appropriate,

Stochastic or DeterministicScenarios

Notwithstanding
thetitle
oftheWorkingParty,itwasfelt
that
workinthisarea
asfar as
actuaries
areconcerned
should
notbeconfined tostochastic
modelling.
There
were not
aninsignificant
numberofcasesorevenpossiblymajority
wherea deterministic
scenario
approachwasmoreappropriate.
Itwasoften mucheasier
toevaluate
modelsin terms
ofthephysical
world
inthecontext
ofthedeterministic
scenario
andalso could
often be
easierfor
theactuary
toexplain
totheend user.
Computing time isoften anissue
with
stochastic
models.
This
isespecially
important
witha largecomplex organisation.
Approximations
maybenecessary
for
day to day
runningofsuchmodels andthis
isanarea
where
research
isbeing
carried
out outside
theactuarial
profession.

Asset Liability
Issues in Other Areas

Stochastic
asset
liability
modellingisnot just
ofinterest
tothegeneral
insurance
actuary
but
there
isalso
interest
inthelife
andpensions andbanking
areas.Indeed
boththelife
andpensions
boards
haveworking partiesinthis
areaandtheprofession
needsto
undertake
morecoordination
inthis
field.

2
Pension
Funds
Thefocus forpension
fundmodelling
istherecently
introduced
Minimum
Solvency
Standard. Inparticular,
stochastic
asset
liability
modelling
isusedtoanswer
thefollowing
questions:
Whatistheprobability ofthefund’s
solvency
position
failing
belowa specified
level
ina slated period oftime
given
aninitial
investment
allocation
and level of
pension
contributions?
What istheprobability
that
thesum ofpension
contributions
and special
payments
into
thefund
will
exceed
a specified
amount
during
a stated periodof
time,
givenaninitial
investment
allocation
andminimumsolvency
criterion.
Itispossible
toincorporate
various
“decision
rules” into
themodel,
depending on the
solvency
position.
Forexample,
themodelmayhavea mechanism bywhich pension
contributions
areassumed
toincrease
orinvestmentstrategy
isassumed
to be modified
if
thesolvency
position
falls
below
a specified
level.
Life
Assurance
Thefocusforlife
assurance
modelling
also
tendstobesolvency-related.
It
is usualfor
there
tobea mechanism
within
themodel
whichrelates
reversionary
andterminal bonus
rates
totheinvestment
returns
generated
bythestochastic
asset
model. Thereare also
typically
a number
oflinkages
between
the
assetandliability
elementsofthemodel, For
example,
surrender
andlapse
rates
mayberelated
toeconomic
conditions.
Asset
Liability
Issues
inBanking
Actuanes
arenotinvolved
toanygreat extent
inthisarea.TheWorking Partywould be
interested
inanyvolunteers
whohaveexperience inthis
area. Itishoweversomething
thattheprofession
needs toinvestigate further
asactivityinthebankingfield
is much
moredeveloped.
Thebanks makeextensive useofriskbased capital
systemsand use
a variety
oftechniques
toevaluate them. Similarly
thevariousderivative
markets use
modelsofvarying
complexitytodetermine marginrequirements.Margin
requirements
wouldbeappropriate
forthose whohaveliabilities
inthisarea. Thisisanareawhere the
WorkingParty
intends
to do more work.
Application
ofWorkinOther
Fields
toGeneral
Insurance
Forpensions fundsandlife
assurancecompanies
mostofthestochastic
variabilitylies
ontheasset side
ofthebalance
sheet.Liabilities
arefixedinmonetary
terms, related to
salariesorrelatedtoinvestment
returns.
There
isa muchgreaterelementof stochastic
variabilityontheliability
sideofthebalance
sheetofa generalinsurancecompany,
involving forexample variable
claim
amounts,
theinsurance cycle
and exposureto
catastrophes. Thismeansthat,although
stochastic
assetliability
modelling work
undertaken for
pensionfundsandlife
assurance
companies istransferable
to general
insurance, themodels usedforgeneral
insurance
companies will
inevitably
be more
complicated.

3
TheWorking Party’s
initial
reaction
is
that
thebanking
liabilities
andassets
are
somewhat
different
from the
insurance
industry
andmaynot
bedirectly
applicable.
Howeverthe
interesting
aspect
is
howsuch
organisations
have
been
using
as a modelling
tomanage
their
affairs,
Time Horizons

Thetime horizon
for
which
the
work
ofparticular
studies
required
is
extremely
important.
Some investment
models
aresuitable
for
short
term
activities,
others
more
appropriate
for long term.
Similar
issues
arise
onthe
liability
side
though
these
are
probably less
important.
Review of Investment Models

Thepurpose
ofthis
section
is
toreview
the
principal
features
ofthe investment
models
which
are
potentially
available
for
stochastic
asset
liability
modelling.
There
aretwomain
types
ofinvestment
model:
Random
walk
models,
in
which
the
future
is
independent
ofthe
past,except that
the
model
hasameanandstandard
deviation
derived
frompast
experience.
Models
where
there
arecorrelations
from
timeperiod
totimeperiod.Insucha
model,
asharp
fall
ininvestment
markets
maybemorelikely
tobe followed bya
rise
than
afurther
fall.
Anexampleofsuchamodel
istheWilkieinvestment
model,
which
is
described
in
thepaper
entitled
“More
onastochastic
asset model
for
actuarial
use:presented
tothe
Institute
ofActuaries
on24April1995.
Most
investment
models
areeither
linear
orlog
linear
intheir
basic
forms
There
areanumber
ofvariants
from
these
basic
models
including
the
following:
It
is
possible
tobuild
elements
ofnon-linearity
into
these
models
by,
for
example,
setting
aminimum
interest
rate
orreducing
the
probability
ofnegative
inflation.
It
ispossible
tolinkthestandard
deviation
underlying
the model toan economic
variable
such asinflation,
toachieve
anelementofheteroscedascity.
Somemodelsare designedtooperate
overthe short
term, whereas others are more
appropriate
forlongtermmodelling.
Longterminvestment
models tend tobeused by
pension
funds
andlifeassurance
companies.However,shortterm models maybeof
moreinterest
togeneral
insurance
companiesinview
ofthe shorterterm nature oftheir
liabilities.
Inprinciple,
shorttermmodelsshouldbemore appropriate for general
insurance
companies becausetheyareabletoincorporate
extraneous econometric
information
suchasfactory
price
inflation
andothergovernmentestimates andforecasts.
However,
the
benefitsofthis
arediluted
becauseeconomicforecasts frequently prove
tobeinaccurate.
Forexample,the
BankofEnglandhas
consistentlyoverestimated retail
price
inflation
during
thepastfewyears.
Somewould arguethatlonger term models are

4
appropriate
for
general
insurance
companies
if
usedwith
appropriate
initial
conditions,
There
area number
ofdrawbacks
which
apply
tomanyinvestment
models:
ManymodelsusetheNormaldistribution.
However, experience
suggeststhat
this
maybeafallacious
assumption.
Thereisa tendencyfor
outcomes
to bunch
either
inthemiddle
ofthedistribution
orattheextremes.
Manyrandom
walkmodels onlymodel
total
return
anddonotconsider
separately
yield
andcapital
appreciation,
There
area numberofinterest
rate
models
whichareusedinoption
pricing,for
example
Hot Lee;
& Rendleman& Barter;
CoxIngersoll
& Ross.However, there
tends
tobenolink
inthese
models
with
inflation
andequity
market
performance.
Eventhemostbasic
modelsarecomplex
and not easy to understand
and
interpret.
This
commentapplies
with
evengreater
forcetoenhanced model,
incorporating
for
example
thefeatures
described
in4above.
Confidentaility
ofInvestment
Models
One oftheproblemstheWorking
Partyfaced
whencontemplating
evaluating the
appropriateness
ofinvestment
modelsisconfidentiality.
Wheremodels have been
developed
forproprietary
trading
needs,there
isa clear
conflict.
Evenlonger term
modelswerefelt
bysomeorganisations
tohaveprojection
value.
Whilethismay be
understandable
it
isanimpediment
todevelopment
inthis
area.
It
alsocreates
problems
fortheprofession
orevenindividual
actuaries
establishing
public
acceptability
forthe
modelsandapproach
used.

Review of Liability
Models

Themodels
canberegardedasbeing
separated
soastoanalyse twodifferent
risks; the
underwriting
risk
andthereserving
riskInaddition
tothese
itisimportantfor
theactuary
toconsider
theimpactofmodelerror.Clearly
this
isa very complex
topicand well
beyond
thescope ofthis
analysis
atthisstage.
Howeverit ISanimportant
sourceof
variation
andjustignoring
itisgoing
toleadtomisleading
results.
Underwriting
Risk
There
arenormally
twotypes
ofapproach.
Frequency
severity
/ models
andtheCentral
Limit
Theorem.
Frequency
Severity
/ Models
Theseareperhapsthemostcommonapproach. Claims
frequencyis modelled
separately
fromseverity
often
usingeither
a Poisson
orNegative
Bissonial
distribution.
Claimsseverity
isthen
looked
atseparately
using
appropriate
distribution
models often
a log
normal
orpareto
distribution
being
used.Theconvolution
ofthedistributions
isthen
usually
found
bysimulation
thoughother
approximate
methods
areusedto sometimes

5
speedupcomputation.
Muchhasbeenwritten
inthis
areaanditisa topic worthy of
discussion
inits
ownright.
It
isalso
important
tonotethat
separate
distributionswillbe
required
for
eachclass
ofbusiness.
It
will
alsobenecessary
tounderstand that cross
correlations
betweenclasses
andother
aspects
ofthemodel
areveryimportant..
Central
Limit
Theorem
Formanyclasses
ofbusiness
for
thesetypes
ofmodelsthecentrallimit theoremis
appropriate
anda normal
distribution
canbeutilised
for
a combinedfrequency I seventy
distribution.
Thiscanreduce
theamountofcomputation
required
substantially.
Reserving
Risk
This
isanarea
wherework
isbeing
carriedoutbytheprofession.
Reserving
risk
can be
regarded
asthe‘run
off’
ofunderwriting
risk. Cross
correlations
between
classesof
business
aswell
asbetweenyears
are important.
Insurance
Cycle
Theinsurance
cycle
hasa majorimpact ontheinsurance
industry.
Variousefforts
have
beenattempted
toincorporate
it.
TheFinnish workinthis
areahassuper
imposed cycles
onits
methodology.
Timeseriesanalysis canbeusedtosatisfactorily
model. Some of
themorepredictable
cycles
suchasmotor. Itishowever
anareawheremuch research
isrequired
butisnevertheless
important.
Gross or Net
Whether
themodelling
isdonegrossornetwilldepend onthecircumstances
ofthe
organisation
andtheextent
ofthereinsurance
programme.
Reinsurance
Bad Debts
Whether
themodelling
isdonegross ornet, itisnecessary
tofactor
in reinsurance
bad
debts.Thisisa difficult
area
andwherefurther research
isrequired.
Clearlysome
companies
canfail
andit
ispossibletobuild upmodels based
onpastfailures.
Itisalso
important
torealisethat
theevents forwhich reinsurance
mayberequiredare those
which
arelikely
toputpressure
on reinsurers.
Economic
Variables
Much workhasbeendoneon investmentmodelsandliability
models separately.
Howevereconomic
variables
affect
both
sidesofthebalance
sheet
andthese needto
befactored
in.Currency
mismatching
andinflation
rates
arealso
issues wheresome
economicresearch
hasbeencarried
outbutwhereonly
a limited
amount ofeffort has
beenmadetoincorporate
thisinto
theinsurance
industry
modelling
process.

6
 Uses of Asset Liability
Modelling
Integrating
asset management
andliability
issues
isa clearadvantage ofsuchmodels.
Apart
fromthetechnical complexities,
organisational
get in the way. The structure
required
is included.

Integrating Investment Perfomance and Copmpany Perfomance

FLOW OF MANAGEMENT INFORMATION

Flow of funds

Efficient
frontier
conceptsapply
equallytoassetliability
/ models asthey
do to asset
models.
Thegreater
generality
allowstrade
offs
between
liability
risks
andasset risks,
This
isillustrated
inthediagram
below.

The Efficient
Frontier
ConceptComes From
Modern Portfolio
Theory

Portfolio
Risk

7
Solvency
Issues
Clearly
asset
liability
modellingisundertaken
toevaluate
solvency
issues.Thetopic has
beendiscussed
inmuchoftheFinnishworkandthe DaykinHay
& paper.However much
ofthis
workisbased onthetechniquesinvolvedandnotonwhatappropriatesolvency
standards
are.Theyarealso normally
couched inprobability
ofruintypeapproaches.
Howeverotherissues areimportant. One isthatitistantamounttofraud foran
insurance
company tooffer
a policy
that
it
doesnothavethecapital
to meet even though
theprobability
ofruinorlossis acceptable
toit.
Model
errorisalso
anextremely
important
point here. It
isdifficult
enoughto evaluate
whatisan acceptable
probability
ofruingiven themodelspecification.
Ignoring the
modelerrorrenders
theoriginal
conceptunhelpful. Hereit
isespecially
important to
remember
we areactuaries
andnot
just
statisticians.

Capital
Requirements
Formostorganisations
solvency
isprobably
notthemostsensitive
criterion.
For most
financial
Institutions,
its
solvency
shouldbeparamount.Certainly
regulators
are going
tobe concerned aboutthis.However itislikely
that
thethreshold
ofpain foran
organisation
becomes toogreat
wellbefore
itssolvency
isthreatened.
Consequentlyit
will
havedifferentcapital
requirements
inorder tomaintain
stability.
These may be
couchedmoreinterms ofshorttermdeviations
ofresults
rather
thanlongterm
probabilities
ofruin.
RiskBased Capital
This
isa whole
newarea
fortheinsurance
industry
andactuaries. Lloyd’s
andtheUS
authorities
aredoing
muchworkinthis
area.Theintroductionofrisk
basedcapital
systems
will
addanextra
constraint
into
asset
liability
modelling.
Insurance
Derivatives
Much workhasbeengoing inrecent
yearstodevelopalternative risktransfer
mechanisms.
Themostcommonofthesearetheinsurance
derivatives introduced by
CBOT.Volume iscontinuing
toincrease
andanencouraging
number of contractsare
being
allowed
toexpire.
However
volumes
donotasyetsatisfyanybody for
this tobe
described
asa success
though
thetrends
arestill
intheright
direction.
A numberofplayers
claim
that
thereisquite
a lot
ofspecially
negotiated
or OTC deals.
Ifsothis
islikely
toencourage
moretradingon CBOT. Even OTC arrangements are
likely
tofeedoff
eachother.
Theprobleminassessingthevolumeinthisarea is that
as
thepotential
players
areendeavouring
toestablish
marketleadership,
theremaywellbe
someexaggerationintheamount
ofbusinessthatisbeingclaimed
to be undertaken.
Nevertheless
there
isclearly
growinginterest
inthis
area
CBOT isintroducing
a crop
insurance
contract.
Thisisimportant
asitwill
encourage
somefurther
diversification.
Cropinsurance,
ofcourse,
fits
moreneatly
intotheother
activities
ofCBOTandeffectively
provides
a meansofdiversification
for
soft
commodity

8
traders.
If
thisleads tomoreactivity
inthis
area
itislikely
toencourage
interest
inother
insurance
derivatives.
CBOT also
hasplans tolist
nine
state
andregional
Catastrophe
InsuranceOptions
contracts.
Thecontracts
will
bebased
onanewbenchmark
indexofinsured
catastrophe
loss
estimates
provided
byProperty
Claims
Services
“PCS”,
a subsidiary
oftheAmerican
Insurance
Service
Group.
The underlying
instrumentforthenew PCS insurance
options
will
be the PCS loss
indices
which
will
trackinsuredloss
estimates
onanindustry-wide
basis
from catastrophe
events
identified
byPCS for eachstate
andregion
listed.
Thevalue
ofeachindex will
becomputed
daily
by PCS.
Small andlargecapoptions
will
belisted
for
eachindex.
Thesmallcapoptions contract
tracks aggregate
industry
lossestimates
between
$0and$20billion. Thelarge cap
options contract
will
track
aggregate
industry
loss
estimates
between
$20 and $50 billion.
Hedgers andinvestors
notonly
havea choice
between
a small
orlargecap contract for
eachindex, butalsoinchoosing
a six
ortwelve
month
developing
period afterthe loss
period.
Itisworth
noting
that
the
concept
ofinsurance
futures
hasmore-or-less
disappeared and
thatall
thetrading
action
onCBOT isincall
option
spreads.
Thisis much more akin to
a layered
excess
ofloss
contract.
Itislikely
that
this
trend
will
continue.
Therehasbeensomeeffort todevelop
a UK insurance
index.
This isalmost
certainly
a necessary
forerunner
tothedevelopment ofanyUK contracts.
Itisalsolikely
that if
a
UK indexissuccessfully
setupitwill
betheforerunner
ofseveralEuropeanindices.
Some dialogue
hasbeentaking place
between theABIandtheIndexWorking Party.
Whilenoannouncements areimminent
itisnotinconceivable
thatwe could
see a UK
index
within
thenext
two years.

O:\WPDOCS\GENERALURO739SH.G95