Case Study on Asset-Liability Management Jeffery Yong IAIS Secretariat Regional Training Seminar IAIS-ASSAL San Salvador, 24 November 2010

Case Study on Case Study on Asset-Liability Management Asset-Liability Management

Jeffery YongIAIS Secretariat

Regional Training Seminar IAIS-ASSAL

San Salvador, 24 November 2010

Case Study on Asset-Liability Management 224 Nov 2010San Salvador

Agenda

1. Introduction

2. IAIS standards and guidance on ALM

3. ALM process and techniques

4. Examples of ALM problems

5. Summary


What is ALM?What is ALM?

FormulateStrategy

ImplementStrategy

MonitorStrategy

ReviseStrategy

ASSETS | LIABILITIES

Risk Tolerance

Firm’s Objectives


ALM should be part of an ERM frameworkALM should be part of an ERM framework

Own Risk and Solvency Assessment (ORSA)

Continuity Analysis Economic and Regulatory Capital

Risk Tolerance StatementRisk Management Policy

Feedback Loop

Feedback Loop

Role of Supervision

Governance and an ERM Framework

Include ALM

policy


Agenda

1. Introduction




5. Summary


Standards on ALM

• Investment Standard 15.4: The solvency regime requires the insurer to invest in a manner that is appropriate to the nature of its liabilities.

• ERM Standard 16.4: The solvency regime requires the insurer to have risk management policy which includes an explicit ALM policy which clearly specifies the nature, role and extent of ALM activities and their relationship with produce development, pricing functions and investment management.


Guidance on ALM Policy

• ALM policy should describe interaction between assets and liabilities:

– how liability cashflows will be met by cash inflows.

– how economic valuation of assets and liabilities will change under a range of different scenarios.

• Does not imply perfect asset-liability matching – mismatches should be managed.

• ALM policy should be proportionate to the nature, scale and complexity of the insurer’s business.


ALM policy should recognise correlationsALM policy should recognise correlations

• Correlation of risk between different asset classes and between different business lines should be taken into account.

• Correlations may not be linear.

Example of correlation matrix: Solvency II QIS 5


Segmentation of business

• Identifying homogenous segments of liabilities and obtaining investments for each segment may be appropriate. Example:

- Non-life business ring-fenced from life business

- Separate participating funds

• Managing blocks of business together may be more optimal because:

- Natural hedge – longevity vs. mortality risks

- Diversification

- Economies of scale


ALM and GovernanceALM and Governance

Board of Directors

Senior Management

Risk ManagementCommittee

Pricing InvestmentsPolicy

AdministrationALM Function

• Implement ALM policy

• Regular reporting

Independent but liaise closely

Approve strategic ALM policy

• Monitor and assess ALM risks• Clear mandate and roles

Structure ≈ nature, scale and complexity of the insurer


Agenda

1. Introduction




5. Summary


Fundamental Steps in the ALM Process

Set risk tolerance

Identify risks

Quantify risks

Implement strategy

Monitor risk

• Set risk/reward objectives• Assess policyholder expectations

• Identify material risks from assets and liabilities; and external factors

• Use appropriate techniques• Assess cost-benefit (e.g. capital)

• Apply business and professional judgement to formulate and implement optimal ALM strategies

• Monitor risk exposures• Revise ALM strategies and modeling

assumptions


Setting risk tolerance levels in practiceSetting risk tolerance levels in practice

• “We use the Group’s 99% Tail VaR in the definition of our risk tolerance, which is the maximum amount of risk we are willing to accept within constraints imposed by our capital resources, as well as by the regulatory and rating agency environment within which we operate.”

• “The Risk Committee of the Board serves as a focal point for oversight regarding the Group’s risk management, in particular the Group’s risk tolerance, including agreed limits that the Board regards as acceptable for us to bear.”

• “We define and monitor aggregate risk limits for our earnings volatility and our capital requirements based on financial and non-financial stresses…the Group meets its internal economic capital requirements, the Group achieves its desired target rating to meet its business objectives, and supervisory intervention is avoided.”


Major types of risksMajor types of risks

Note: List is not exhaustive.


Quantification of risks – an exampleQuantification of risks – an example


ALM Techniques – Liquidity Ratio

Liquidity Ratio: Ratio of assets that can be sold within a given time horizon to liabilities that may be called within the time horizon. Should be > 100% for all time horizons.

<1yr 1yr – 2 yr 2yr – 3yr 3yr – 4 yr

ASSETS THAT CAN BE SOLD

Bonds

Cash

Policy Loans

Real Estate

10,000

5,000

15,000

7,000

7,000

8,000

15,000

20,000

10,000

20,000

Sub-total 15,000 22,000 30,000 50,000

LIABILITIES THAT CAN BE CALLED UPON

Technical Provisions

Senior Debt

Other Liabilities

10,000

2,000

12,000

5,000

1,000

25,000

10,000

1,500

20,000

12,000

2,000

Sub-total 12,000 18,000 36,500 34,000

Liquidity ratio

[Assets / Liabilities] %

125% 122% 82% 147%


ALM Techniques – Duration/Convexity Matching

Duration and Convexity Matching: Select assets so that changes in their value arising from interest rate movements match those of the liabilities.When the duration of the assets and liabilities matches, their present values will move in sync when interest rate changes.

T=0 T=1 T=2 T=3

5 5 105Bond cashflow

86.2

)05.1(105

)05.1(5

)05.1(5

)05.1(3105

)05.1(25

)05.1(15

)1(

)1(

321

321

1

1

n

tt

t

n

tt

t

iCFi

tCF

Duration

Discount at 5%

Discount at 5%

Discount at 5%


ALM Techniques – Scenario Testing

Scenario testing (deterministic or stochastic): Calculate losses under specific scenarios.

Swiss Solvency Test scenario example:

• Shares, real estate and hedge funds 30%

• Yield curves 300 bps in all currencies

• Lapse rate 25% during one year and then goes back to normal

• Volume of new business is 25% of an average year.

• In case of policyholder surrender the insurer cannot reduce the redemption value for contracts which are older than 5 years for group pension business

• All companies from the insurance and reinsurance market are downgraded by 3 notches.


ALM Techniques – VaR/TVaR

Value at Risk (VaR): Percentile measure (e.g. 99%) of distribution of losses under possible scenarios.

Tail Value at Risk (TVaR): Expected loss conditional on losses being above a given percentile.

Probability

Losses99% percentile

VaR @ 99%

TVaR @ 99%

(average of shaded area)


Agenda

1. Introduction




5. Summary


Effects of asset-liability mismatchEffects of asset-liability mismatch

• The rise in interest rates causes a fall in the value of assets by more than the fall in value of liabilities.

• As a result, the company becomes insolvent.

Initial Present

Value (PV) DurationPV after 200bps ↑ in

interest rates

Assets 200 5 200 - 5 X 2% X 200 = 180

Liabilities 190 2 190 - 2 X 2% X 190 = 182.4

Surplus/(Deficit) 10 -2.4


Another example of ALM problemsAnother example of ALM problems

Company Profile

• Sells whole life policies offering guaranteed cash surrender values.

• Assets consist of long-term bonds with payments matched to expected mortality and surrender experience.

• All assets are reported at amortized cost.

Stress Scenario:Interest rates hike

Market value of assets fall

Increased surrenders

Forced sale of assetsbelow book values

LESSONS?


Lessons learnt from the exampleLessons learnt from the example

• Use appropriate metrics to measure exposure to market risk – liability profile may change under different market environment.

• Take into account risks posed by options embedded in new and in-force policies – options and guarantees.

• Establish plan to deal with unexpected cash outflows – liquidity management.


Agenda

1. Introduction




5. Summary


Summary and concluding remarksSummary and concluding remarks

• Assets should be managed in conjunction with liabilities of an insurer.

• Sound ALM policies should be embedded within an insurer’s ERM framework.

• ALM requirements should be proportionate to the nature, scale and complexity of the insurer’s business.

• Governance structures are important to ensure ALM processes are implemented appropriately.


Thank you for your attention. Any questions/ comments?

[email protected]

Documents

Case Study on Asset-Liability Management Jeffery Yong IAIS Secretariat Regional Training Seminar IAIS-ASSAL San Salvador, 24 November 2010