ALM and pricing of life insurance products

1. ALM and pricing of life insurance products Vladimír Krejčí Prague, 1 April 2004

2. Main tasks of ALM • Investment strategy • Product design and pricing • Capital and risk management

3. Product design and pricing • Design • Passing the investment risk to clients • Possibility to hedge the risk borne by shareholders • Pricing (profit testing) • Reasonable assumptions about • Future yields • Discount rate

4. Let‘s start – question 1 • Does profitability of a life insurance product depend on investment strategy?

5. Example 1 • Single premium endowment without profit sharing • Policy term 10 years • Zero mortality and lapse rates • Let‘s assume 2 scenarios of investments • a) 10Y government zero coupon bond • b) 10Y corporate zero coupon bond

6. Traditional DCF approach • Let‘s measure profitability in the form of Value Added by New Business • Different investment return assumptions • a) VANB = EUR 10 • b) VANB = EUR 15 • RDR increased by 2% in b) • a) VANB = EUR 10 • b) VANB = EUR 12 • Possibility to increase allocated capital

7. Alternative approach • The same cashflows in the first day • Premium paid, expenses • After the first day: • Liabilities: the same in both a) and b) (technical reserves of EUR 100) • Assets: • a) EUR 100 in government bond • b) EUR 100 in corporate bond

8. Alternative approach In other words:

9. „We do not invest risk free and therefore our yields will be higher than risk free.“ • Risky investment strategy increases the profit potential • You can make more profits if you are good (succesful, lucky) • But it increases the loss potential as well • „…our yields will be probably higher…“ • => it does not increase market value

10. Does profitability of this life insurance product depend on investment strategy? • Traditional DCF • YES • Alternative approach • NO • What approach is more appropriate?

11. Question 2 • Is market value the appropriate measure? • Why do we have different PV? • Information, investment horizon, risk attitude • What decisions are we willing to base on our PV?

12. Credit risk • Corporate bond from the example 1 valued via DCF • Expected future cashflow • Notional amount * (1 - probability of default*(1-recovery rate)) • We could also allow for cost of capital • PV = EUR 102,5 • Isn‘t this PV the right one from our shareholders‘ point of view?

13. Why is the market price different? • What factors we did not allow for? • Market can expect different probability of default • Potential downgrades • Volatility of credit spreads • Market can have different cost of capital • Investors are risk averse

14. How did the market arrive at the price? • Supply / Demand • consensus of market participants • Who are market participants? • Banks, insurance companies, investment funds, … • Komercni banka, CSOB, Ceska sporitelna, Ceska pojistovna, ING, Deutsche bank, Morgan Stanley, Meril Lynch, Bank of America, Credit Lyonais, … • Very well educated, trained and experienced teams • Very well informed teams – equally informed • Efficient market

15. Stock markets • Forward on stocks – what is the forward price? • Expected yield (arbitrage) • Risk free yield • Stock returns over a long horizon • Sentiment, trends, bull/bear markets

16. Interest rates risk, duration mismatch • What do we estimate? • Macroeconomic development • Decisions of billions of people all around the world • Estimate of these decisions by thousands of analysts and market players • Sentiment, media, psychology, hedging • Time horizon

17. Why is our PV different than market value? • Do we have better know how? • Are we better informed? • Are the markets efficient? • Do we really have arguments for the PV we have calculated?

18. Why is our PV different than market value? • We do not have better information, so … • …our shareholders have to be differently risk averse than the market… • do we know their utility function that well? • …or not interested in short term results • what about if the investment strategy reports high losses and we say these are only temporary?

19. Is market value the appropriate measure for us? • What decision are we willing to base on our PV?

20. What decisions are we willing to base on our PV? • Purchase of particular security • Investment strategy • Liability product design and pricing

21. Summary • Is market value the appropriate measure for valuation of life insurance liabilities? • Does profitability of this life insurance product depend on investment strategy?

22. A practical problem

23. A practical problem Profit in life insurance is a small sum of • Large positive numbers • Premium income, investment income • Large negative numbers • Claims, expenses • It is very difficult to adjust the discount rate to particular investment assumptions

24. The problem – cont. The smaller the profit, the bigger the problem • Low interest rate environment • Lower margins are relatively more sensitive to changes in investment income • Products with profit sharing • Change in profit sharing • Change in company‘s margin • Do we have market evidence for use of the traditional EV in M&A?

25. Suggested solution • EV with risk free investment returns and risk free discount • Do we know to evaluate the mortality, lapse, expense, … risks? • Risk free EV can be some comparative basis – the traditional EV should not be higher (negative value of mortality, lapse, expense, … risks)

26. Suggestion 2 • EV with cashflow specific discount rates

27. Products with profit sharing • Short introduction

28. What about products with profit sharing? • Risky investment strategy increases the profitability (compared to risk free strategy) if you pass to clients more risks and less profits • If you pass to clients more profits than risks then: • The riskier investments, the lower profitability

29. What about products with profit sharing? • How to compare the passed profits and risks? • Contingent claims valuation methods • Low interest rate environment • Very low expected profit sharing rates • Limited space for passing the risk (= losses) • Simple estimate on passing more profits/risk may be possible