Case Study on Asset-Liability Management

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

Agenda • Introduction • IAIS standards and guidance on ALM • ALM process and techniques • Examples of ALM problems • Summary Case Study on Asset-Liability Management

What is ALM? Risk Tolerance ASSETS | LIABILITIES Firm’s Objectives Case Study on Asset-Liability Management

Governance and an ERM Framework Risk Tolerance Statement Risk Management Policy Feedback Loop Own Risk and Solvency Assessment (ORSA) Feedback Loop Continuity Analysis Economic and Regulatory Capital Role of Supervision ALM should be part of an ERM framework Include ALM policy Case Study on Asset-Liability Management

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

ALM 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 Case Study on Asset-Liability Management

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 Case Study on Asset-Liability Management

ALM and Governance Approve strategic ALM policy Independent but liaise closely • Monitor and assess ALM risks • Clear mandate and roles Structure ≈ nature, scale and complexity of the insurer Case Study on Asset-Liability Management

Fundamental Steps in the ALM Process Set risk tolerance Identify risks • Set risk/reward objectives • Assess policyholder expectations Quantify risks • Identify material risks from assets and liabilities; and external factors Implement strategy • Use appropriate techniques • Assess cost-benefit (e.g. capital) • Apply business and professional judgement to formulate and implement optimal ALM strategies Monitor risk • Monitor risk exposures • Revise ALM strategies and modeling assumptions Case Study on Asset-Liability Management

Setting 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.” Case Study on Asset-Liability Management

Major types of risks Case Study on Asset-Liability Management Note: List is not exhaustive.

Quantification of risks – an example Case Study on Asset-Liability Management

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. Case Study on Asset-Liability Management

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. 5 5 105 Bond cashflow T=0 T=1 T=2 T=3 Discount at 5% Discount at 5% Discount at 5% Case Study on Asset-Liability Management

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. Case Study on Asset-Liability Management

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 VaR @ 99% TVaR @ 99% (average of shaded area) Losses 99% percentile Case Study on Asset-Liability Management

Effects 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. Case Study on Asset-Liability Management

Another example of ALM problems Stress Scenario: Interest rates hike Market value of assets fall 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. Increased surrenders Forced sale of assets below book values LESSONS? Case Study on Asset-Liability Management

Lessons 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. Case Study on Asset-Liability Management

Summary 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. Case Study on Asset-Liability Management

Thank you for your attention. Any questions/ comments? jeffery.yong@bis.org www.iaisweb.org Case Study on Asset-Liability Management

Case Study on Asset-Liability Management