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

Case Study on Asset-Liability Management2 24 Nov 2010 San Salvador Agenda 1.Introduction 2.IAIS standards and guidance on ALM 3.ALM process and techniques 4.Examples of ALM problems 5.Summary

Case Study on Asset-Liability Management3 24 Nov 2010 San Salvador What is ALM? Formulate Strategy Implement Strategy Monitor Strategy Revise Strategy ASSETS | LIABILITIES Risk Tolerance Firm’s Objectives

Case Study on Asset-Liability Management4 24 Nov 2010 San Salvador ALM should be part of an ERM framework Own Risk and Solvency Assessment (ORSA) Continuity Analysis Economic and Regulatory Capital Risk Tolerance Statement Risk Management Policy Feedback Loop Role of Supervision Governance and an ERM Framework Include ALM policy

Case Study on Asset-Liability Management5 24 Nov 2010 San Salvador Agenda 1.Introduction 2.IAIS standards and guidance on ALM 3.ALM process and techniques 4.Examples of ALM problems 5.Summary

Case Study on Asset-Liability Management6 24 Nov 2010 San Salvador 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 Management7 24 Nov 2010 San Salvador 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 Management8 24 Nov 2010 San Salvador 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 Management9 24 Nov 2010 San Salvador 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 Management10 24 Nov 2010 San Salvador ALM and Governance 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

Case Study on Asset-Liability Management11 24 Nov 2010 San Salvador Agenda 1.Introduction 2.IAIS standards and guidance on ALM 3.ALM process and techniques 4.Examples of ALM problems 5.Summary

Case Study on Asset-Liability Management12 24 Nov 2010 San Salvador 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

Case Study on Asset-Liability Management13 24 Nov 2010 San Salvador 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 Management14 24 Nov 2010 San Salvador Major types of risks Note: List is not exhaustive.

Case Study on Asset-Liability Management15 24 Nov 2010 San Salvador Quantification of risks – an example

Case Study on Asset-Liability Management16 24 Nov 2010 San Salvador 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. <1yr1yr – 2 yr2yr – 3yr3yr – 4 yr ASSETS THAT CAN BE SOLD Bonds Cash Policy Loans Real Estate 10,000 5,000 15,000 7,000 8,000 15,000 20,000 10,000 20,000 Sub-total15,00022,00030,00050,000 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-total12,00018,00036,50034,000 Liquidity ratio [Assets / Liabilities] % 125%122%82%147%

Case Study on Asset-Liability Management17 24 Nov 2010 San Salvador 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= Bond cashflow Discount at 5%

Case Study on Asset-Liability Management18 24 Nov 2010 San Salvador 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 Management19 24 Nov 2010 San Salvador 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 Losses 99% percentile 99% 99% (average of shaded area)

Case Study on Asset-Liability Management20 24 Nov 2010 San Salvador Agenda 1.Introduction 2.IAIS standards and guidance on ALM 3.ALM process and techniques 4.Examples of ALM problems 5.Summary

Case Study on Asset-Liability Management21 24 Nov 2010 San Salvador 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. Initial Present Value (PV)Duration PV after 200bps ↑ in interest rates Assets X 2% X 200 = 180 Liabilities X 2% X 190 = Surplus/(Deficit)10-2.4

Case Study on Asset-Liability Management22 24 Nov 2010 San Salvador Another 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 assets below book values LESSONS?

Case Study on Asset-Liability Management23 24 Nov 2010 San Salvador 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 Management24 24 Nov 2010 San Salvador Agenda 1.Introduction 2.IAIS standards and guidance on ALM 3.ALM process and techniques 4.Examples of ALM problems 5.Summary

Case Study on Asset-Liability Management25 24 Nov 2010 San Salvador 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 Management26 24 Nov 2010 San Salvador Thank you for your attention. Any questions/ comments?