Case Study on
Asset-Liability Management
Jeffery Yong
IAIS Secretariat
Regional Training Seminar IAIS-ASSAL
San Salvador, 24 November 2010
Agenda
1. Introduction
2. IAIS standards and guidance on ALM
3. ALM process and techniques
4. Examples of ALM problems
5. Summary
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What is ALM?
Risk Tolerance
Revise
Strategy
Formulate
Strategy
ASSETS | LIABILITIES
Monitor
Strategy
Implement
Strategy
Firm’s Objectives
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ALM should be part of an ERM framework
Governance and an ERM Framework
Risk Tolerance Statement
Risk Management Policy
Include
ALM
policy
Feedback Loop
Own Risk and Solvency Assessment (ORSA)
Feedback Loop
Continuity Analysis
Economic and Regulatory Capital
Role of Supervision
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Agenda
1. Introduction
2. IAIS standards and guidance on ALM
3. ALM process and techniques
4. Examples of ALM problems
5. Summary
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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.
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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.
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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
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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
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ALM and Governance
Board of
Directors
• Implement
ALM policy
• Regular
reporting
Approve
strategic ALM
policy
Risk
Management
Committee
Senior
Management
Independent but
liaise closely
Pricing
Investments
Policy
Administration
• Monitor and
assess ALM
ALM Function risks
• Clear
mandate and
roles
Structure ≈ nature, scale and complexity of the insurer
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Agenda
1. Introduction
2. IAIS standards and guidance on ALM
3. ALM process and techniques
4. Examples of ALM problems
5. Summary
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Fundamental Steps in the ALM Process
Set risk tolerance
• Set risk/reward objectives
• Assess policyholder expectations
Identify risks
• Identify material risks from assets
and liabilities; and external factors
Quantify risks
Implement strategy
Monitor risk
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• 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
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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.”
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Major types of risks
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Note: List is not exhaustive.
Quantification of risks – an example
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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
ASSETS THAT CAN BE SOLD
Bonds
Cash
Policy Loans
Real Estate
2yr – 3yr
3yr – 4 yr
15,000
7,000
20,000
10,000
5,000
7,000
8,000
15,000
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
125%
122%
82%
147%
Liquidity ratio
[Assets / Liabilities] %
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1yr – 2 yr
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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.
n


Duration
t 1
n
CF t  t
(1  i )
t
Bond
cashflow

(1 . 05 )

5

(1 . 05 )
1
 2 . 86
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T=1
T=2
105
T=3
t
t 1
1
5
CF t
 (1  i )
5 1
T=0
5
5 2

(1 . 05 )
5
2

(1 . 05 )
2
105  3
(1 . 05 )
105
3
(1 . 05 )
3
Discount
at 5%
Case Study on Asset-Liability Management
Discount
at 5%
Discount
at 5%
17
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.
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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)
99%
percentile
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Losses
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Agenda
1. Introduction
2. IAIS standards and guidance on ALM
3. ALM process and techniques
4. Examples of ALM problems
5. Summary
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Effects of asset-liability mismatch
Initial Present
Value (PV)
Duration
PV 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
• 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.
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Another example of ALM problems
Company Profile
• Sells whole life policies
offering guaranteed cash
surrender values.
• Assets consist of longterm 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 assets
below book values
LESSONS?
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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.
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Agenda
1. Introduction
2. IAIS standards and guidance on ALM
3. ALM process and techniques
4. Examples of ALM problems
5. Summary
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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.
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Thank you for your attention.
Any questions/ comments?
jeffery.yong@bis.org
www.iaisweb.org
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