Panning - Managing Interest Rate Risk

Question 1

Three important points about franchise value (the implications of franchise value on ALM):

Answer 1

i. Franchise value is significant for many P&C insurers even though accounting rules refuse to recognize the fact.
ii. Franchise value is exposed to interest rate risk. Since the franchise value reflects the present value of the future cash flows from renewals (and “new” business), its value will vary as interest rates change. ALM ignores franchise value and focuses on assets and liabilities recognized by accounting rules.
iii. Franchise value is often unmeasured, unreported and consequently unmanaged by the firm. Thus, ALM will remain incomplete because it fails to assist firms in managing this significant but invisible component of their total economic value.

Question 2

Managing the Interest Sensitivity of Franchise Value - two critical points

Answer 2

1. Limits of Using Investment Strategies to Manage Interest Rate Risk — The larger the firm’s franchise value, the more problematic it will be to manage the interest rate risk for the total economic value using asset investment strategies.
2. Invisibility of Franchise Value — Because the franchise value is invisible to outside parties such as rating agencies and regulators (as well as investors), strategies to manage this risk may actually appear to increase the risk. The figures shown on the balance sheet will suggest a large duration mismatch and the complex, negative duration assets will likely appear risky.

Question 3

Advantage of Using Pricing Strategy to Manage Duration of Total Economic Value

Answer 3

Find a combination of the strategy parameters a and b such that the return on surplus and the duration of total economic value are both acceptable.

It avoids the potential rating agency and regulatory risk. This key advantage results from the fact that implementing a pricing strategy is nearly as invisible to these external audiences as the franchise value it is intended to protect.

Question 4

Dilemma if the insurance company uses traditional duration-matching to manage its interest rate risk.

Answer 4

When duration of franchise value is too high, it is diffculat to transform assets in order to match the durations. The duration of assets has to be near 0 or negative. It would create rating agency and regulatory problems as they only see accounting numbers and they would see this strategy as increasing risk.

Question 5

The duration of future premium is significantly higher than the duration of losses and expenses. Briefly explain how is this possible when premiums and expenses are received and paid simultaneously, and losses are paid a year later?

Answer 5

Premium cash flows are interest-sensitive.

• When interest rate rise (y rise), premium cash flows become smaller due to the pricing policy assumed (P = {S(k-y)+L}/1+y +E )
• When premiums are interest-sensitive, a rise in interest rate has double impact
  
  • PV of each dollar future premiums decline
  • # of premiums also decline

The second effect can be changed by adopting a different pricing strategy.