QFIP-139-19: IAA Risk Book Ch 13 - ALM Flashcards
Definition of ALM
ALM is an 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
- Under ALM, assets are not managed separately against a benchmark
- Instead, assets are purchased with the intent of supporting future liability cashflow
- ALM also considers capital requirements associated with any assets that are purchased
Describe how ALM is different between life insurance companies and P&C companies
- Life insurers have long duration liabilities that are primarily focused on interest rate risk
- P&C firms have shorter-term liabilities and are more exposed to catastrophes and mispricing
- More focused on maintaining liquidity, given the uncertainty of cash outflows
Describe the elements of measuring risk exposure in ALM
- Use metrics such as duration, convexity, and scenario testing to measure sensitivity of assets/liabilities to changes in interest rates, equity levels, etc
- One can also simulate the risk distribution of the assets and liabilities under stochastic simulation, and compute risk measures such as VAR and CTE
Describe the elements of managing risk exposure in ALM
- This involves using traditional ALM metrics, such as duration and convexity, to set risk limits and rebalance the portfolio when needed
- For example, suppose we had a criteria that the percentage difference between the duration of the assets and liabilities cannot be greater than 2.5%
- If this risk limit is ever breached, than we would rebalance the portfolio by purchasing or selling assets to realign the asset and liability durations
Why do life insurance companies struggle under a prolonged low interest rate
environment?
- Difficult to earn returns on the asset portfolio that were assumed during pricing of the life insurance products
- A rapid decline in interest rates can hurt insurance companies due to their convexity exposure
- Possible for the duration of liabilities to increase by a greater amount than the duration of the assets
- Difficult to immunize traditional guaranteed products with long durations
- Such long-term assets are not available
- Companies may not want to invest in long-term, low-yield bonds and lock in losses
List a few ways insurance companies can increase the return on their asset portfolio during a low interest rate environment
- Investing in bonds with lower credit quality
- Increasing allocation to riskier asset classes such as equities, real estate, etc
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Increasing yield-to-maturity in an upward sloping term structure
- Sell shorter duration assets with lower yields, and buy longer duration assets with higher yields
- Transfer risk to new policyholders by replacing sales of traditional guaranteed products with unit linked products
- Hedging against the risk of interest rates falling (i.e. swaps, floors)
List some basic questions that one should ask before performing ALM
- What sources of financial risk fall within the scope of ALM?
- Which risk exposure matters, and which does not?
- On what basis should risk be measured and managed?
- What assets and liabilities should be included and which, if any, should be excluded?
- At what aggregation level should ALM be performed?
Compare and contrast using ALM as a risk mitigation exercise vs. using ALM as part of a strategic decison making framework
- Some companies execute ALM as a risk mitigation exercise
- In this case, the goal is simply to track the risk exposure of the firm’s surplus and make sure it is within specified risk limits
- Example: Make sure that asset duration is always within 1% of liability duration
- Other firms integrate ALM within a broader ERM and strategic decision making framework
- The goal is to achieve a certain financial objective, subject to risk tolerances and constraints
- Example: Asset portfolio must return 7% annually, while still being within 2% of the liability duration
Other objectives for an ALM function
- Demonstrating to internal and external stakeholders that the company is being well managed
- Minimizing capital requirements
- Determining how much interest should be credited to policyholders
List three different basis companies can use for measuring risk exposure
A challenge for insurance companies is when there is a disconnect between the economic and accounting/regulatory results from ALM
- For example insurance companies may say they are focused on long term economic value in ALM when measuring risk
- However, they may be reluctant to immunize interest rate exposure on an economic basis if it creates losses on a book value basis based on accounting laws
List different ways risk limits for interest rate risk can be expressed
- The difference between the dollar duration of assets and liabilities must be less than X% of asset value
- The net partial duration sensitivity must be less than Y% of the asset value at all yield curve points
- The worst case scenario must be less than Z% of asset value
List different sources of risk for life insurance companies that are typically within the scope of an ALM program
- Interest rate risk
- Liquidity risk
- Credit risk
- Currency risk
- Market risk
- Associated with losses in market value of non-fixed income (NFI) assets, such a equity or real estate
Different dimensions of interest rate risk in ALM
- Standard measures such as duration can hedge against parallel shifts in the yield curve
- Immunizing based on key rate duration can protect against nonparallel shifts
- Hedging based on effective duration can help protect against liabilities with embedded options that have cashflows sensitive to interest rates
- To cover all possible dimensions, such as the changes in rates over time, deterministic scenarios or stochastic simulation would be required
Describe three methods for measuring the interest rate risk of NFI assets backing liabilities
- Model real estate and equities as bonds with a fixed equity risk premium when calculating their duration
-
Not too accurate, though, as the change in price of equities/real estate
will not necessarily move in the direction predicted using duration
-
Not too accurate, though, as the change in price of equities/real estate
- Perform sensitivity analysis for various deterministic interest rate and equity return scenarios
- Use a stochastic model that generates economic scenarios, and then obtain a probability distribution of surplus
Describe what the carveout strategy is
A carve-out strategy explicitly separates out the long-term liability cash flows after a certain number of years (called the carve-out point)
- Standard fixed income assets would be used to immunize the short-term liability cashflows that occur before the carveout period
- NFI assets would be used to back the long-term liability cashflows that occur after the carveout period
- This method allows an insurer to explicitly measure and manage the risk exposure associated with using NFI assets to back the long-term liabilities
