QFIP-139: IAA Risk Book Ch 13 - ALM Flashcards
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
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
- 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 (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
List three different basis companies can use for measuring risk exposure
- Protect economic surplus by minimizing the volatility of:
PVpAssetCFsq PVpLiabilityCFsq - Protect market value by minimizing the volatility of: MVpAssetsqMVpLiabilitiesq
- Protect accounting results by minimizing the volatility of:
BVpAssetsq BVpLiabilitiesq
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
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 - 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
What are two different methods for determining the carve-out point for liabilities?
- Use the latest tenor where liability cash flows can be effectively immunized with
available fixed income assets
The remaining amount of assets is invested in NFI securities - Determine the amount of exposure to NFI assets first, and then determine the
carve-out point based on how many years of cash flows the NFI assets can
support
Example: Allocate 30% of the asset portfolio to NFI assets, which can support
long-term liability cashflows that occur past 40 years from now
List some best practices of ALM governance
Have the board of directors and senior management promote ALM
The ALM committee has experienced individuals with the necessary expertise
Roles and responsibility are clearly defined
Reports are created that clearly communicate the risk profile of the insurance
company and supports decision making
Risk is consolidated at the company level and understood by senior management
Compare and contrast having an ALM framework’s financial objective be based on
economic results vs. accounting results
Focusing on economic reality (based on actual cash flows) ensures the
organization can realize higher earnings over the long-term
However, focusing on accounting results can have short-term benefits because
these are the results that currently get reported to shareholders, rating agencies,
etc
