IAIS-ASSAL Training Seminar Ixtapa, Mexico, April 2009 Shinichi Kishi – Principal Administrator International Association of Insurance Supervisors (IAIS) Case Study on Asset Liability Management

Case Study on ALM2 April 2009 Shinichi Kishi Outline 1.Introduction 2.ICPs and Standards on ALM 3.Mini Case Study

Case Study on ALM3 April 2009 Shinichi Kishi 3 1. Introduction ALM is defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve and organisation’s financial objectives, given the organisation’s risk tolerances and constraints

Case Study on ALM4 April 2009 Shinichi Kishi 4 1. Example 1. Example –Example: Company ABC has 200M in assets, 190M in liabilities, 10M in capital and surplus –Duration of assets is 5 years while duration of liabilities is 2 years –Duration is a fundamental measure of interest rate sensitivity, roughly equivalent to average remaining term to maturity. Definition:

Case Study on ALM5 April 2009 Shinichi Kishi 5 1. Example What happens if interest rates go up by 200 basis points (2%)? The value of the assets goes down by 20M (Duration x Change in Interest Rate x Current Value = 5 x 2% x $200M = $20M) The value of the liabilities goes down by only 7.6M$ (2 x 2% x $190M) The company’s capital drops by $12.4M and the company goes bankrupt

Case Study on ALM6 April 2009 Shinichi Kishi 6 1. Introduction Lack of an appropriate ALM framework has caused many insolvencies in the past. ALM helps insurers balance competing and legitimate objectives for growth, profit and risk. In the previous example, the intent would not be to completely match the duration of assets and liabilities since this may reduce the investment income of the company to an unacceptably low level.

Case Study on ALM7 April 2009 Shinichi Kishi 7 1. Introduction The intent is to make sure that the risk exposure determined by the ALM process is within management’s acceptable limits If exposure exceeds these limits then the investment or liability portfolio must be modified to bring the risk exposure back within the limits.

Case Study on ALM8 April 2009 Shinichi Kishi 8 1. Introduction Insurers should apply techniques appropriate for the nature of their business and the risks they undertake Every insurer should have an ALM policy, but not all ALM risks need to be assessed using complex techniques

Case Study on ALM9 April 2009 Shinichi Kishi 9 2. Basic Issues ALM looks at all risks requiring coordination of the insurer’s assets and liabilities, especially market risk, underwriting risk and liquidity risk The objective is not to eliminate risk, but to manage risks within a framework that includes self-imposed limits The key to ALM is to understand and forecast changes in economic value using company and market data, appropriate company and industry specific assumptions and appropriate financial models

Case Study on ALM10 April 2009 Shinichi Kishi Outline 1.Introduction 2.ICPs and Standards on ALM 3.Mini Case Study

Case Study on ALM11 April 2009 Shinichi Kishi ICPs on ALM ICP 18: Risk assessment and management: The supervisory authority requires insurers to recognise the range of risks that they face and to assess and manage them effectively. Requires comprehensive risk management policies and systems Appropriate to the complexity, size and nature of the insurer’s business A key control is asset/liability management

Case Study on ALM12 April 2009 Shinichi Kishi ICPs on ALM ICP 21: Investments: The supervisory authority requires insurers to comply with standards on investment activities. These standards include requirements on investment policy, asset mix, validation, diversification, asset-liability matching and risk management. Requires effective procedures for monitoring and managing asset-liability positions to ensure that investment activities and asset positions are appropriate to liability and risk profiles

Case Study on ALM13 April 2009 Shinichi Kishi Requirements for ALM I.The supervisor requires that insurers have in place effective procedures for monitoring and managing their asset- liability positions to ensure that their assets and investment activities are appropriate to their liability and risk profiles and their solvency positions. Standard on Asset-Liability Management adopted in October 2006 sets 11 requirements

Case Study on ALM14 April 2009 Shinichi Kishi 14 II.ALM should be based on economic value and should consider the change in economic value that will arise from a range of plausible scenarios. Accounting and regulatory values that involve non-economic considerations and conventions may also be considered within an ALM framework, representing additional constraints on the cash flows valued. 2. Requirements for ALM

Case Study on ALM15 April 2009 Shinichi Kishi 15 III.The ALM measurement tools used should be appropriate to the nature and the circumstances of the insurer and the risk characteristics of the line of business. 2. Requirements for ALM

Case Study on ALM16 April 2009 Shinichi Kishi 16 IV.The insurer should examine all risks requiring the coordination of its assets and liabilities. The ones that are significant in terms of their potential impact on economic value should be covered by an ALM framework. These may include, in whole or in part: i.Market risk interest rate risk (including variations in market credit spreads equity, real estate and other asset value risks currency risk related credit risk ii.Underwriting risk – including claims and expense risks iii.Liquidity risk 2. Requirements for ALM

Case Study on ALM17 April 2009 Shinichi Kishi 17 V.The insurer should use appropriate metrics to measure exposure to market risk and related credit risk. More sophisticated models should be used for more complex portfolios of products and investments in order to model the portfolios reliably. 2. Requirements for ALM

Case Study on ALM18 April 2009 Shinichi Kishi 18 VI.The insurer should take into account risks posed by options embedded in new and in-force policies. It should identify ways to mitigate the impact of the options, while ensuring that policyholders are treated fairly. ALM should assess the possible effects such embedded options can have throughout the life of the insurance policies. 2. Requirements for ALM

Case Study on ALM19 April 2009 Shinichi Kishi 19 VII.The insurer should structure its assets so that it has sufficient cash and diversified marketable securities to meet its obligations as they fall due. The insurer should have a plan to deal with unexpected cash outflows, by such means as holding sufficient liquid or readily marketable assets or by having a formal credit facility. 2. Requirements for ALM

Case Study on ALM20 April 2009 Shinichi Kishi 20 VIII.The board of directors should approve the insurer’s strategic ALM policy, taking account of asset-liability relationships, the insurer’s overall risk tolerance, risk and return requirements, solvency position and liquidity requirements. Senior management is responsible for implementing ALM policy. 2. Requirements for ALM

Case Study on ALM21 April 2009 Shinichi Kishi 21 IX.In formulating its overall strategy, an insurer should consider the ALM strategies appropriate to the characteristics of each distinct block of business, and should also take into account the interaction between blocks. 2. Requirements for ALM

Case Study on ALM22 April 2009 Shinichi Kishi 22 X.The insurer should be organized so that there is a close and continuing liaison between the different areas that need to be involved with ALM. The organisational structure depends on the nature, size and complexity of the insurer, and should enable the organisation to maintain effective ALM. To the extent practicable, the monitoring of ALM risk and processes should be organisationally separate from the functions overseeing investments, pricing and management of in-force business. The mandate, roles and responsibilities of the ALM function should be clear, appropriate and well understood within the insurer. The supervisor should examine whether the interrelationship of functions is appropriate. 2. Requirements for ALM

Case Study on ALM23 April 2009 Shinichi Kishi 23 XI.The insurer should develop and implement controls and reporting procedures for its ALM policies that are appropriate for its business and the risks to which it is exposed. These should be monitored closely and reviewed regularly. 2. Requirements for ALM

Case Study on ALM24 April 2009 Shinichi Kishi Outline 1.Introduction 2.ICPs and Standards on ALM 3.Mini Case Study

Case Study on ALM25 April 2009 Shinichi Kishi 3. Mini Case Study on ALM Imagine your are a supervisor in the process of conducting an on-site review of the Asset Liability Management (ALM) function for one of the insurance companies incorporated in your jurisdiction. Section I – Making an analysis of the ALM programme Any concerns regarding the ALM programme of the subsidiary (SCAL) under your supervision? Please identify your concerns? Discuss in a group and identify concerns about the SCAL’s ALM programme (30 min.) Make a presentation of your group’s findings (5-10 min. per group)

Case Study on ALM26 April 2009 Shinichi Kishi 3. Mini Case Study on ALM Section II – Preparing an assessment report Your manager recommends that you include a couple of recommendations in your assessment report. What are your reactions to these recommendations? Discuss in a group how to react to your manager’s recommendations (20 min.) Make a presentation of your group’s views (5-10 min. per group)

Case Study on ALM27 April 2009 Shinichi Kishi International Association of Insurance Supervisors (IAIS) Questions and Answers