Docstoc

Managing Assets and Liabilities-Strategies for Insurance Companies

Document Sample
Managing Assets and Liabilities-Strategies for Insurance Companies Powered By Docstoc
					Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Financial Services Commission of Jamaica Insurance Seminar - October 30, 2008 Michael Hafeman, FSA, FCIA, MAAA

Context for Asset-Liability Management Risks and Risk Tolerance Risk Measurement ALM Techniques Organizational Issues Supervisory Objectives

Managing Assets and Liabilities: Strategies for Insurance Companies

2

What is it and why is it used?

Managing Assets and Liabilities: Strategies for Insurance Companies

3

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

ALM is the ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities to achieve financial objectives, for a given set of risk tolerances and constraints.

Society of Actuaries

Managing Assets and Liabilities: Strategies for Insurance Companies

4

Managing Assets and Liabilities: Strategies for Insurance Companies

5

Managing Assets and Liabilities: Strategies for Insurance Companies

6

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Profits mostly on spread Cash flows to reinvest Liabilities payable on pre-set dates Difficult to find assets to match liability flows Embedded options Investment performance guarantees Potential reinsurance settlement time lags Claims volatility

Managing Assets and Liabilities: Strategies for Insurance Companies

7

Nissan Mutual: long-term rate guarantees General American: cashable debt instruments Baldwin United: long-term assets and liabilities that became short-term Jamaica financial crisis
◦ Deposit-like liabilities ◦ Long-term real estate assets ◦ Interest rates increased

Asset values declined Liquidity was inadequate to meet liabilities

Managing Assets and Liabilities: Strategies for Insurance Companies

8

All lines of business All risks requiring asset-liability coordination Economic value
◦ Value of future cash flows, consistent with market prices ◦ Best basis for a consistent ALM program and achievable objectives

Optimize economic value… subject to constraints
Managing Assets and Liabilities: Strategies for Insurance Companies 9

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

What is risk and how much can be tolerated?

Managing Assets and Liabilities: Strategies for Insurance Companies

10

Risk is the exposure to an uncertain event or outcome that has a financial impact on an entity
◦ Non-systematic risk can be reduced or eliminated by diversification ◦ Systematic risk is the residual risk that cannot be eliminated by diversification within a given market

Managing Assets and Liabilities: Strategies for Insurance Companies

11

Risk can be hedged – designing a portfolio with cash flows that offset another portfolio’s cash flows in certain scenarios Liabilities and their supporting assets can be mutually dependent The risk environment is constantly changing – even if the portfolios of assets and liabilities are not!

Managing Assets and Liabilities: Strategies for Insurance Companies

12

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Credit Market
◦ ◦ ◦ ◦

Liquidity

Interest rate Equity and real estate Currency Related credit risk (derivatives) ◦ Asset-liability mismatch

Underwriting Operational Group Systemic Many risks can be either on- or offbalance-sheet (OBS)

Managing Assets and Liabilities: Strategies for Insurance Companies

13

Exposure of an entity’s financial condition to movements in interest rates Interest rate movements can affect the level, timing and economic value of both asset and liability cash flows

Managing Assets and Liabilities: Strategies for Insurance Companies

14

Managing Assets and Liabilities: Strategies for Insurance Companies

15

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

The risk that an entity, though solvent, has insufficient liquid assets to meet its obligations when they fall due

Managing Assets and Liabilities: Strategies for Insurance Companies

16

Liquidation value risk – unexpected timing or amounts of needed cash may require liquidation when market conditions result in loss of value Affiliated investment risk – investments in affiliates may be difficult to sell or affiliates may create a drain on resources Capital funding risk – entity will be unable to obtain sufficient outside funding when needed
Managing Assets and Liabilities: Strategies for Insurance Companies 17

Underwriting process risk Pricing risk Product design risk Claims risk (frequency, severity, development) Economic environment risk (inflation) Net retention risk (catastrophe, concentration) Policyholder behavior risk Reserving risk

Managing Assets and Liabilities: Strategies for Insurance Companies

18

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Shareholder expectations Management philosophy Capital capacity Supervisory requirements Rating agency requirements

Managing Assets and Liabilities: Strategies for Insurance Companies

19

Variability of economic value Variability of net income Variability of economic capital Change in amount of new business Limits may be overall, by line of business, or by type of risk

Managing Assets and Liabilities: Strategies for Insurance Companies

20

How can the risks be quantified?

Managing Assets and Liabilities: Strategies for Insurance Companies

21

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

ALM requires the projection of cash flows from both assets and liabilities The timing and amount of some cash flows are highly predictable, but many are not Computer models are essential tools, but the reliability of their output depends on the methods, assumptions and data used

Managing Assets and Liabilities: Strategies for Insurance Companies

22

Liquidity ratios Cash flow testing Duration and convexity Value at risk (VaR) Scenario testing Economic capital

Managing Assets and Liabilities: Strategies for Insurance Companies

23

Ratio of liquid assets to anticipated shortterm liability cash flows Multiple time horizons might be considered

Managing Assets and Liabilities: Strategies for Insurance Companies

24

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Project cash flows under various interest rate scenarios Examine the adequacy of asset cash flows to meet liability cash flows under each scenario Example: NAIC requirements
◦ Address only interest rate risk ◦ Exclude new business ◦ May be subject to manipulation

Managing Assets and Liabilities: Strategies for Insurance Companies

25

Measures the sensitivity of the value of a series of cash flows to changes in interest rates Duration is approximately the average point at which the projected cash flows occur For example, if a portfolio of assets has a duration of 4, a 1% increase in interest rates will cause a 4% decrease in its value

Managing Assets and Liabilities: Strategies for Insurance Companies

26

Measures the sensitivity of the duration of a series of cash flows to changes in interest rates Convexity measures how rapidly duration changes as interest rates change Compare duration and convexity of assets with those of liabilities

Managing Assets and Liabilities: Strategies for Insurance Companies

27

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Probability-based boundary on losses Frequently used by banks for measuring risk in the trading portfolio Requires a lot of historical data Tail VaR (or Conditional Tail Expectation-CTE) may be a better measure for catastrophe risks
◦ For a specified holding period ◦ For a specified confidence level

Managing Assets and Liabilities: Strategies for Insurance Companies

28

Project financial results under different scenarios to assess the effects of risks Deterministic – define specific scenarios Stochastic – generate scenarios using probability distributions Related terminology and uses:
◦ ◦ ◦ ◦ Dynamic financial analysis (DFA) Dynamic capital adequacy testing (DCAT) Stress testing Economic capital calculation

Managing Assets and Liabilities: Strategies for Insurance Companies

29

Assets required, in excess of liabilities, to avoid ruin at a given confidence level For example, achieving a rating of AA may require economic capital sufficient to have a 99.3-99.5% probability of avoiding ruin over a period of one year Calculated using stochastic scenario testing According to a 2006 Tillinghast global survey, 65% of insurers calculate economic capital and another 19% are considering it
Managing Assets and Liabilities: Strategies for Insurance Companies 30

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

How can the risks be managed?

Managing Assets and Liabilities: Strategies for Insurance Companies

31

Product design Diversification
◦ Assets ◦ Liabilities

◦ Risk sharing with policyholders ◦ Low monetary guarantees

Customer relationship management Reinsurance Line of credit

Managing Assets and Liabilities: Strategies for Insurance Companies

32

Create portfolios with offsetting cash flows Uses Scope
◦ Reduce systemic or non-diversifiable risk ◦ Deal with product options and guarantees ◦ For a business segment ◦ Across business segments ◦ Static or dynamic ◦ Rely on business cash flows or supplement with derivatives

Approaches

Managing Assets and Liabilities: Strategies for Insurance Companies

33

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Possible risks created
◦ ◦ ◦ ◦

Shortcomings

Credit - underlying instrument Basis - imperfect or partial hedging Market - use of derivatives Liquidity - collateral on derivative transactions

◦ Uncertainty of cash flows ◦ Less flexibility to take advantage of opportunities ◦ May conflict with views on market

Managing Assets and Liabilities: Strategies for Insurance Companies

34

Project cash flows Structure portfolios to match asset and liability cash flows Eliminates interest rate risk, in theory Uncertainty of cash flows makes perfect matching impossible Limits flexibility and opportunity to benefit from taking mismatch risk

Managing Assets and Liabilities: Strategies for Insurance Companies

35

Structure portfolios so that the impact of a change in interest rates on the value of liabilities offsets the corresponding impact on asset values Achieved by matching the durations of assets and liabilities Matching convexity, as well, helps to avoid losing the matching of durations as rates change

Managing Assets and Liabilities: Strategies for Insurance Companies

36

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Uncertainty of liability cash flows makes it difficult to estimate duration Duration and convexity are valid only:
◦ For parallel shifts of the yield curve ◦ Within a small range of interest rates ◦ For a single currency

◦ Cash surrenders, catastrophe claims, and so forth

Deals only with repricing risk, not yield curve, basis or optionality risks Useful as a rule of thumb, but it is not a complete approach to ALM
Managing Assets and Liabilities: Strategies for Insurance Companies 37

Model Components
◦ ◦ ◦ ◦ ◦

Assumptions-initial conditions Scenario generator Financial calculator Optimizer Output-results

Managing Assets and Liabilities: Strategies for Insurance Companies

38

How can we implement ALM?

Managing Assets and Liabilities: Strategies for Insurance Companies

39

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Investment Product design Pricing Valuation Marketing Information technology Finance Treasury Risk management

Managing Assets and Liabilities: Strategies for Insurance Companies

40

Size Nature of business Complexity of business

Managing Assets and Liabilities: Strategies for Insurance Companies

41

Personnel Software Information Internal, external, or a combination

Managing Assets and Liabilities: Strategies for Insurance Companies

42

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Board and management information Policies and procedures Separation of responsibilities Dealing with breaches of limits Conflict resolution

Managing Assets and Liabilities: Strategies for Insurance Companies

43

What are the FSC’s interests in ALM?

Managing Assets and Liabilities: Strategies for Insurance Companies

44

Promote the adoption of procedures designed to control and manage risk, for use by the management, boards of directors and trustees… Take such steps as are necessary to ensure that appropriate standards of conduct and performance are maintained…

FSC Act, section 6

Managing Assets and Liabilities: Strategies for Insurance Companies

45

Managing Assets and Liabilities: Strategies for Insurance Companies

October 2008

Board of directors approves an economic value-based strategic ALM policy Senior management implements the policy A close and continuing liaison among those areas that need to be involved with ALM Effective procedures for monitoring and managing asset-liability positions ALM tools are appropriate to the nature and circumstances of the insurer and the risk characteristics of its lines of business
Managing Assets and Liabilities: Strategies for Insurance Companies 46

IAIS Insurance Core Principles (ICPs) require insurers to adequately manage risks, including those addressed by ALM ICPs require supervisors to assess the adequacy of risk management IAIS Standard on Asset-Liability Management (2006) provides more details on the expectations of both insurers and the supervisor

Managing Assets and Liabilities: Strategies for Insurance Companies

47

ALM can both manage risks and increase economic value ALM can benefit a wide range of stakeholders ALM requires not only technical capabilities but top-down support

Questions and comments?

Managing Assets and Liabilities: Strategies for Insurance Companies

48


				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:37
posted:8/10/2009
language:English
pages:16