Asset Liability Management at Munich Reinsurance Company

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					Asset Liability Management at
Munich Reinsurance Company

Helsinki, 17th November 2004


Bernhard Kaufmann and Jochen Mayer
Asset-liability management for insurance companies

Agenda


   ALM: Governance and Management

   The Munich Re ALM-Model: ALM on Macro Level

          The general Concept

          The different modules

          Reports and Analysis

   ALM and pricing: ALM on Micro Level




                                                     2
Asset-liability management for insurance companies

Strategic objectives for ALM




                                      Deliver a return to shareholders
                                        in excess of cost of capital

    Operational profitability         Business focus             Risk limitation      Financial strength

     – Strict underwriting      – Reinsurance                - Comprehensive risk   – Retain clients’ and
       discipline                                              management             investors’ confidence
                                  •    Focus on achieving
                                       a leading market
     – Rigorous application            position in target    – Integrated view on   – Reduce dependency
       of Value Based                  markets depending       insurance risk and     on equity market
       Management                      on the cycle            financial mismatch     developments,
                                                               risk                   thereby increasing
     – Commitment to              •    Exit business not                              flexibility
                                       achieving target
       financial targets                                     – De-risk balance
                                       returns
                                                               sheet
                                – Primary insurance
                                  •    Strong platform for
                                       profitable growth
                                  •    Sustainable
                                       strengthening of
                                       business model

                                                                                                              3
Asset-liability management for insurance companies

Evolution of ALM in global insurance market

                                                                   • Development of coherent Integrated Risk Management
                                                                     Framework
                                                               4   • ALM processes integrated with active capital management
         66% of                                                      and other financial risk management processes
      insurers are                                                 • Governance processes provides independent oversight of
                                                                     aggregate financial risk position
     less than 50%
       of the way                               • ALM function and processes developed to integrate risk
      through the                                 profiles of both assets and liabilities
      evolutionary                            3 • Management action focused on the integrated asset and
                                                  liability view
        journey                                 • Governance process provides independent oversight of
                                                  ALM



                                  • Enhanced awareness of the value of formalized ALM
                                    process                                                                     90% of
                             2    • Development of partially integrated asset and liability                   insurers
                                    measurement processes
                                                                                                             believe that
                                  • ALM governance primarily focused on asset-side
                                                                                                              benefits
                                                                                                            outweigh the
                • Identification, measurement and monitoring of asset                                       costs of the
           1      and liability risks undertaken in isolation, with varying
                  degrees of sophistication                                                                    journey
                • Limited or informal / ad hoc integration of individual
                  risk profiles


Source: Ernst & Young LLP. 2004                                                                                                4
Asset-liability management for insurance companies

ALM in the Solvency II project


Special Call for advise from CEIOPS (MARKT/2506/04-EN – App.2):


        … “In the future all insurance undertakings need to have an asset-liability
        management system (ALM) as part of their general business and risk
        management processes. General principles concerning A/L analysis shall be
        harmonized at the EU level.”…



        ... “One major use for ALM in pillar I is to contribute to investment planning.” …

         … “standard formula for calculating the solvency capital requirement should
        capture the ALM risk in a sufficiently prudent approach.” …



        … “The pillar II supervisory review process should encompass the undertaking’s
        ALM.” …


                                                                                             5
Asset-liability management for insurance companies

ALM Governance of Munich Re Group



                                             ALM
                                          GOVERNANCE


     LIABILITIES       REPLICATING         STRATEGIC             TACTICAL           ASSETS
                        PORTFOLIO            ASSET                ASSET
                                          ALLOCATION            ALLOCATION
  Stochastic          Portfolio of        Asset allocation     Asset allocation   The risks and
  representation of   assets that most    targets that         targets that are   cash flows
  cash flows          closely matches     provide optimal      selected by the    associated with
  associated with     the risk            level of return      Asset Manager      assets of the
  insurance and       characteristics     given the            to optimize        Group
  reinsurance         associated with     predetermined        return within
  obligations on a    the stochastic      appetite of Board    given
  class of business   representation of   and other            investment and
                      the liabilities     investment           risk constraints
                                          constraints, as
                                          dictated by
                                          external
                                          stakeholders (e.g.
                                          regulators, rating
                                          agencies)
                                                                                                    6
Asset-liability management for insurance companies

Agenda


   ALM: Governance and Management

   The Munich Re ALM-Model: ALM on Macro Level

          The general concept

          The different modules

          Reports and Analysis

   ALM and pricing: ALM on Micro Level




                                                     7
Asset-liability management for insurance companies

What would happen if? The ALM model is an
evaluation tool
      An optimisation tool                                                              The AL-team analyses the
   generates, for example, a                                                             simulated results for the
   strategic asset allocation                                                          considered SAA and trades
                                                                                           off risks and chances
                                                                                 “The AL-team”
                    “The optimiser”




                                           “The ALM model”


                                           Capital market model




                                                                  Liability model
                            Asset module
                                                                  Life      Non life




                                             Corporate model
                                                                                    The ALM model simulates the
                                                                                    implications of the considered
                                                                                     SAA over a 5 year horizon in
                                                  Reports
                                                                                    combination with the liabilities


                                                                                                                       8
Asset-liability management for insurance companies

The ALM model allows to analyse the impact of
strategic decisions and changes in the general framework
                               General framework
                                  Accounting rules

                                     Regulation



    Volatility sources                                  Distributions of
                                                       corporate results
      Capital market                    ALM-            Balance sheet
        scenarios                       Model
                                                        P&L statement
         Operative
         business                                        Risk positions


                                 Strategic decision
                                 Investment strategy

                                 Operative strategy
                                                                           9
Asset-liability management for insurance companies

Agenda


   ALM: Governance and Management

   The Munich Re ALM-Model: ALM on Macro Level

          The general Concept

          The different modules

          Reports and Analysis

   ALM and pricing: ALM on Micro Level




                                                     10
Asset-liability management for insurance companies

The different Modules



                                    Capital market model



                   Asset model                              Liability model




                                       Corporate model

                                         Sub models
                                        HGB          IFRS



                                           Reports


                                                                              11
Asset-liability management for insurance companies

The capital market model: 3000 Scenarios form the basis of
the ALM simulation

                                                       EURO Zinsraten über einen 5-Jahres-Horizont
                      10%

                      9%

                      8%

                      7%
      Interest rate




                      6%

                      5%

                      4%

                      3%

                      2%

                      1%
                            1Y                    3Y                           5Y                        7Y                          10 Y
                                                                             Maturity

                                 1% quantile    5% quantile        10% quantile         25% quantile   50% quantile   75% quantile
                                 90% quantile   95% quantile       99% quantile         start          mean




                         Short term interest rates are more volatile than long term
                       rates
                        For most of the scenarios interest rates are below the
                       average
                        In many of the scenarios the spread between long and
                       short term rates reduces over time
                                                                                                                                            12
Asset-liability management for insurance companies

The capital market model: Equity indices



                                          EUROSTOXX
                             10.000
                              9.000
                              8.000
                              7.000
                              6.000

                     Value
                              5.000
                              4.000
                              3.000
                              2.000
                              1.000
                                 -
                                 1 Year        3 Years   5 Years
                                              Horizon




    The mean of the chosen calibration is clearly positive: 5-
   year return EUROSTOXX: 6,7% p.a.
    The probability of a loss for the EUROSTOXX is
   nevertheless very high at 28%.




                                                                   13
Asset-liability management for insurance companies

The asset model: Focus of the analysis should rule the
granularity of the model
  MODELLING EURO ASSETS - IAS


   Asset Classes                Market value modelling                 Book value modelling IAS

   Governments
                                Interest yield curve (term)            Bonds – Available for sale
   Corporates
                                            +                          Bonds – Held to maturity
                                                              Market
   Pfandbriefe                  Static Spreads
                                                              Value    Bonds – Trading
   Loans
                                (Dynamic Spreads)                      Loans
   (ABS/MBS)

                                Relevant price index and               Affiliated Companies -
   Equities                     divident yield (Eurostoxx)             consolidated
   Participations               Price index and dividend               Affiliated Companies –
   Ergo                         yield (DAX)                   Market   non consolidated
                                                              Value
   Allianz                      Insurance index and                    Associated Companies
                                dividend yield
   HVB                                                                 Equity – Available for sale
                                Banking index and
   Commerzbank                                                         Equity - Trading
                                dividend yield
                                                              Market
   Real Estate                  Relevant real estate index             Real Estate
                                                              Value
                                                              Market
   Cash                         Short term interest rate               Cash
                                                              Value

                                                                                                     14
Asset-liability management for insurance companies

The non life model simulates catastrophe, basic
and large losses based on MR risk model
INCURRED LOSSES AND PROVISIONS FOR OUTSTANDING CLAIMS ARE PROCESSED BY MEANS OF
STOCHASTIC PAY OUT PATTERN

   Flexible premium and budget development (GDP, CPI)
   Consideration of internal/external retrocession and FRe-treaties
   Derivation of commission and admin expenses as ratios of earned premiums

                                                                                             Major Non-Life Loss and Combined Ratios (Mean and Quartiles)

                                                                    210%


                                                                    180%




                             Interaction with
                                                                    150%


                                                                    120%


                                                                      90%


                                                                      60%


                                                                      30%



                                                                      0%




                                                                            2003
                                                                                   2004


                                                                                          2005
                                                                                                 2006
                                                                                                        2007



                                                                                                               2003


                                                                                                                       2004
                                                                                                                              2005
                                                                                                                                     2006


                                                                                                                                            2007


                                                                                                                                                   2003


                                                                                                                                                          2004
                                                                                                                                                                 2005
                                                                                                                                                                        2006


                                                                                                                                                                               2007


                                                                                                                                                                                      2003


                                                                                                                                                                                             2004
                                                                                                                                                                                                    2005
                                                                                                                                                                                                           2006


                                                                                                                                                                                                                  2007
                                                                                      Casualty                        Property                               Marine                            Other




                             other modules
                          Non-Life Module



     Claims     Division Report           Ext. Retro    Finite Re

                 LoB Report

                Currency Report




     Input          Output                      Input     Input
                 Cash Flows
                Balance sheet
              Income statement
                                                                                                                                                                                                                         15
Asset-liability management for insurance companies

Life model: reserving is strongly affected by interest rates




          Average "Umlaufrendite" over 10 years (yield in %)2)


     6
    5.5
     5
    4.5
     4
    3.5
                                                        Change in Interest Sensitive Reserves3)
     3
     2003        2004       2005        2006        2007         2008
                                            0.03
                                           0.025      99%-Quantil
                                            0.02
                                           0.015
                                                       95%-Quantil
                                            0.01
                                           0.005
                                               0
                                               2003          2004          2005         2006      2007




                                                                                                         16
Asset-liability management for insurance companies

Agenda


   ALM: Governance and Management

   The Munich Re ALM-Model: ALM on Macro Level

          The general Concept

          The different modules

          Reports and Analysis

   ALM and pricing: ALM on Micro Level




                                                     17
Asset-liability management for insurance companies

A number of ALM reports can be generated


   International & local GAAP
financial statements



  Capital market model
scenarios


   Risk analysis


   Technical results


   Return and growth


   Investments and
investment result
                                                     18
Asset-liability management for insurance companies

Balance sheet IAS



   €m mean over scenarios

   ASSETS                                                        Actuals 2003       2004           2005           2006         2007
   Intangible assets                                                       131              130            130           130          130

   Investments
      I. Real Estate                                                     1.050             1.040           990           978      1.068
      II. Investments in affiliated and associated enterprises           6.808             6.823          6.825      6.826        6.828
      III. Loans (mortgage loans, loans to aff/ass)                        666              580            582           604          627
      IV. Other Securities
         - Available for sale (excluding Allianz)                       14.459         14.557         14.939        15.764       17.014
         - Available for sale (Allianz only)                             2.347          2.483          2.656         2.884        3.060
         - Trading                                                          56             56             56            56           56
         Total                                                          16.862         17.096         17.651        18.704       20.130
      V. Other investments                                              11.893         12.527         12.620        12.956       13.054
      Total                                                             37.279         38.067         38.667        40.068       41.706

   Ceded share of underwriting provisions                                1.789             1.527          1.503      1.520        1.529
   Other assets                                                          4.499             4.584          4.711      4.729        4.724
   Balancing item Assets                                                        0           410            410           410          410




                                                                                                                                            19
Asset-liability management for insurance companies

The ALM model simulates balance sheet and income
statement numbers for MR AG under HGB and IFRS


      Development of insurance business,                 Assets and investment return
      premiums and claims                            −   Asset structure at book and market
   1. Stochastically simulated figures                   values
      − Incurred losses (gross and net               −   Unrealised capital gains and losses
      expenses for claims and benefits)              −   Net investment return (components)
      − Gross and net underwriting provisions        −   RoI (referring to the average market
   2. (Deterministically) projected figures              value of total investments)
      − Gross and net earned premiums                −   Performance of selected asset classes
      − Gross written premiums                       −   Duration
   3. Derived figures (by ratios)
      − Commission and admin expense ratios
      − Loss ratios (LR)
      − Expense ratios (ER)
                                                         Security and risk measures
      − Combined ratios (CR):= LR + ER
                                                     −   Relevant rating figure (S&P CAR)
      − Ins. business result ratio:= 1 _ LR _ ER     −   Relevant solvability figures (solo
                                                         solvency)
       Rentability                                   −   Value at risk
   −   Return on equity (RoE)                        −   Currency over/under coverage
   −   Comprehensive income per equity               −   Duration missmatch



                                                                                                 20
Asset-liability management for insurance companies

Example 1: Risk/return analysis for different
strategic asset allocations (SAAs)


                Comprehensive Income in € bn
                                                     Unchanged SAA

                                                     Increase in equities
                                                     (SAA with higher risk)
   Mean




                                                     Decrease in equities
                                                     (SAA with lower risk)


                                                           2004       2005
                                                           2006       2007


                      Standard Deviation




                                                                              21
Asset-liability management for insurance companies

Example 2: Impact of dynamic investment
strategies


                                                     Static investment strategy




   Dynamic investment
   strategy linked to VaR-
   limit




                                                                                  22
Asset-liability management for insurance companies

Example 3: Analysis of duration mismatch




   Definition EUR-Duration: =
   Change in market value of assets and
   liabilities if all interest rates change by
   100 basispoints
   EUR-Duration:=
   MacAulay-duration* market value * 0.01
                                                     23
Asset-liability management for insurance companies

Example 4: Analysis of currency mismatch at
book and market value




  Def: Currency mismatch = Market value of assets - Market value of liabilities
                                                                                  24
Asset-liability management for insurance companies

Example 5: Effect of changes in accounting
standards (e.g. after tax profit under IAS 39 old and new)


                                                            IAS Profit (in Billion EUR)
                                                            with 90%-Confidence bands
                    6.0

                    5.0

                    4.0

                    3.0

                    2.0

                    1.0

                    0.0

                    -1.0
                           new 2003




                                                                        new 2005




                                                                                              new 2006




                                                                                                                    new 2007
                                                 new 2004

                                                             old 2004




                                                                                                                               old 2007
                                                                                                         old 2006
                                      old 2003




                                                                                   old 2005




      The graph shows the change of the IAS profit as a result of the first-time
      implementation of IAS 32/39 (rev. 2003) compared to the previous version.


                                                                                                                                          25
Asset-liability management for insurance companies

Agenda


   ALM: Governance and Management

   The Munich Re ALM-Model: ALM on Macro Level

          The general Concept

          The different modules

          Reports and Analysis

   ALM and pricing: ALM on Micro Level




                                                     26
Asset-liability management for insurance companies

Primary Life Insurance – the past must be placed in
perspective, lessons have been learned for the future
                      Max Discount / "Min. G'teed Rate" (1)
                      Market Value Raturn (2)
                      Average Participation Rate (3)

12% PA
  %                                                                                                         Interlinking the
 8%
                                                                                                             Fundamentals
 4%

 0%                                                                                      The Future              ALM
   1994           1996            1998            2000            2002            2004
-4%




                                                                                                                          Dynamic
                                                                                                      Pricing
-8%




                                                                                                                           Bonus
                                                                                                                German
                                                                                                                 Life

        Market Value Earnings   Market Value Earnings
        Exceed Declared Rates   Less than Declared Rates
        (Surpluses Accumulated) (Draw Down of Surplus)
                                                                                                                Hedging
 Start of
 Deregulated
 Market

  (1)     Estimated for 1994 & 1995, Actual for later years
  (2)     Before allowance for Terminal Bonus, typically in the range of 0.3% to 0.5%
  (3)     Rate applying to business written in that year
                                                                                                                               27
Asset-liability management for insurance companies
Securing Risk Adequate Prices in German Primary Life
Business – Market Consistent Pricing of Guarantees

   What is meant by ‘market-consistent’ pricing of a guarantee?

         The cost of a portfolio of assets with the same pay-offs as guarantee
         in all possible scenarios i.e. the cost of hedging risk

   Why is it useful?

         Pricing: Shareholder cost of writing guarantee

         Capital: Minimum capital required to hedge risks. Can indicate drivers
         of risk-based capital requirements

   For simple guarantees, formula may be available:e.g. ‘plain-vanilla’ put
   options => Black Scholes formula

   Insurance guarantees usually more complex : cost dependent on Bonus
   and asset management rules

   Simple formula not available            Use simulation model
                                                                                  28
 Asset-liability management for insurance companies

Improving Capital Productivity Requires Optimising
Management Actions on Both Sides of the Balance Sheet


       Managing the Liabilities                           Managing the Assets

     Bonus Smoothing Policies (Annual &               Defining the Strategic Asset
     Terminal Bonus)                                  Allocation and Portfolio
     Making use of direct bonus                       Rebalancing Rules
     declaration („Direktgutschrift“)                 Developing a sound dynamic
     Consideration of cost of guarantees              hedging strategy
     and embedded options in setting                  Optimising reinvestment and
     bonus rates                                      disinvestment decisions
     Special treatment for policies close             Management of unrealised gains
     to maturity – proactively managing               and losses
     policyholders‘ reasonable
                                                      Flexing the equity backing ratio in
     expectations
                                                      response to changing excess
     Shareholder participation pre and                capital levels
     post 1994 Rules

                                                                                            29
 Asset-liability management for insurance companies

Active ALM can improve the risk/return profile
substantially

                                                                                               German Primary Life Business –
                                                                                                Improving Capital Productivity
     - ILLUSTRATION FOR                                                                                                                                     - ILLUSTRATION FOR
  ENDOWMENT ASSURANCE -                                                                                                                                  ENDOWMENT ASSURANCE -

   MARKET CONSISTENT PRICING
                                                                                                                    Vision                    ASSET/ LIABILITY MANAGEMENT
     Passive Bonus                                  Dynamic Bonus
     Policy – Market                                Policy – Market                                                  Business                 Required Shareholder Risk Capital
       Consistent                                     Consistent                                                      Focus                         Assets Invested in                              Assets Covered
in %                                                                                                                                         in        Bonds (Base                                   by Structured




                                                                                                                                Management
          Cost                                           Cost




                                                                                                     Discipline
AUM1.5                                                                                                                                       %            Case)                                         Hedge


                                                                                                      Pricing
                                                                                                                                                  150%




                                                                                                                                  Risk
                     1.0
          Passive Policy (Market Consistent Cost)
                                                                    .1
                                                     Dynamic Policy (Market Consistent Cost)
                                                                                                                                                                    100
                                                                                                                                                          Passive Policy (Market Consistent Cost)
                                                                                                                                                                                                                   25
                                                                                                                                                                                                      Dynamic Policy (Market Consistent Cost)




     1
                                                                                                                  Strategy                        100%




    0.5                                                                                                                                            50%



     0                                                                                                                                             0%
                                                                                                                   Distribution &
                                                                                                                  Cost Management
                                                                                                                                                            Optimising Investment
  Power of Management
                                                                                                                                                           Strategy for Shareholder
Actions to Reduce Costs of
                                                                                                                                                          Funds Provides Leveraged
   Guarantee & Improve
                                                                                                                                                          Potential to Improve Capital
 Returns for Shareholders
                                                                                                                                                                  Productivity




                                                                                                                                                                                                                                                30
Thank you for your interest.




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