17. Asset liability management Flashcards
SOA defn:
Practice of managing a business s.t. decisions and actions taken wrt to assets and liabilities are co-ordinated
ALM can be defined as ongoing process of formulating, impl, monitoring and revising strategies related to A and L to achieve org’s financial objectives, given its risk tolerances and other constraints
ALM is relevant to and critical for sound management of finances of any org that invests to meet its future cash flow and capital requirements
Two nb components:
A-L matching
A-L modelling
Aims to ensure there’s adequate alignment between A+L and that any mismatch between characteristics of A+L is identified and quantified to …
… ensure it’s still within risk appetite
Tool to make sure enough money to meet liabilities (solvency requirement) and CFs are of such a nature that money available when needed (liquidity requirements)
May be disclosure about matching philosophy to ph
Analytical tool to model and investigate joint behavious of A+L over time, …
… using consistent assumptions (for modelling A, L and interacting between them) about …
… future scenarios and alternative strategic options (e.g. alt investment strategy options)
Example investigations:
Alt investment strategies in terms of risk and suitability
Financial outcomes under alt business strategies
Bonus policies
Influences of risk appetite:
Size of free surplus
Inherent tolerance for A-L mismatch risk
Must clearly and define risk appetite, i.e. amount and composition of mismatch risk willing and able to accept. May use “risk budgeting” process to establish:
Level of mismatch risk to be taken
Where most efficient to take that risk (risk capital requirements and risk-return optimisation)
Must have strategies to effectively manage A-L risks proportionate to nature, size and type of business
Required to have asset-liability management policy under IA (2017)
Clarify key objectives of process or desired output from ALM exercise
E.g.
Future ongoing funding levels
Future solvency levels
Investment guarantee reserves (IGR)
Economic capital
Determine suitable assumptions for parameters and distribution functions (if relevant)
Model specification stage includes:
Establishing CF model to value A+L
Determine which parameters to model stochastically and deterministically
Decide on dynamic links
Include new business?
Choose projection time frame (e.g. 30 years for IGR and 10 years for SCR) and intervals
Collect and validate proper data to use in modelling process and use it to create model pts
Run model and store outputs
Consider overall nature of L
Analyse how results may be influenced if diff investment strategies used by varying deterministic asset allocation assumptions
Assess interaction between risks (increased mismatching) and reward (higher investment returns) by find pt where risk minimised and return maximised
Sensitivity and scenario test
Summarise and present results to help make decisions e.g. relating to investment strategies
Valuation
Valuation for block/all policies using diff deterministic assumptions for future conditions
Gives idea of robustness of solvency and sustainability of bonus policies
Shortcoming- doesn’t identify risks inherent in imprudent options and guarantees
Scenario test annual projected cashflows
Cover wide range if scenarios relevant to SA to check if CFs adequate each year
Assume ph exercise options against life option
Scenario examples:
Hyperinflation like in Zim
Deflation like in Japan
Prolonged collapse in equity MVs like in SA in 1970s
Continued healthy investment conditions
Project cashflows using stochastic models
Helps:
Identify risks arising from guarantees and options
Determine optimum level and extent it can mismatch depending on risk appetite and free assets
Model choice
Must be careful with model chosen
Model risk examples
Inadequate modelling of extreme or tail events
Assuming mean reversion in inappropriate circumstances e.g. market crashes
Test: use historical data to see if company would have met solvency criteria with model
Assumptions
Set out necessary assumptions
Stochastic model contains significant # of assumptions
Ensure interactions are consistent
Model is dynamic when assumptions changed
Other factors:
Projection periods and interval of CFs
Monthly = more reliable pic of investment guarantee and options but more computing resources
Account for other strategies that relate to investment , i.e.
Asset allocation
Bonus philosophy
New business
Dividend declarations
Capital requirements
W/ profits
Matching more difficult due to discretionary part of benefits
Trade-off between ph RBE and safest investment strategy
Conservative»_space; limit mismatching risk»_space; returns not in line with RBE
Split between regular vs terminal and vested vs non-vested affects:
matching requirements
split between conservative and aggressive investments
May use derivatives to balance matching position of w/p and RBEs
W/o profits
E.g. immediate annuities
Significant investment guarantees
Degree of matching impacts risk inherent in business
Bonds and interest rate swaps appropriate for non-profit annuities
Difficulties with availability esp long term contracts
Unit-linked
Bulk of A+L exactly matched»_space; full modelling unnecessary
May be guarantees
Use scenario testing / sensitivity analysis for expenses
If most profits from investment-linked fees:
May be insufficient income in years of low investment returns»_space;
» affects solvency position»_space;
» so must be included in overall stochastic scenarios and monitored as part of overall solvency position
Index -linked
If A don’t mirror underlying index»_space; tracking error risk
Identify and monitor potential tracking errors
Purposes of holding derivatives
Increase available profit / capital
Reduce tax / investment costs
More effectively / efficiently acquire or dispose of positions in relation to assets
Hedge one or more aspects of guarantees provided in w/p contracts
Provide exposure required to match investment guarantees underlying some contracts, e.g. guaranteed equity bonds / variable annuities
When considering using derivatives, would model as above but factor in effect of derivative contract …
… either on A values or in some cases by limiting effects of changing circumstances on L values, …
… and liquidity constraints and costs of derivatives
Often imperfect, e.g. based on index and not actual A portfolio
Determining effectiveness:
Consider appropriate admissibility treatment
Ensure no double counting of benefits
