Requiring ALM Policies A Supervisory Perspective

1
Requiring ALM Policies A Supervisory Perspective

• Asset Liability Management for Insurance
  CompaniesHosted by the Lithuanian Insurance
  Supervisory CommissionVilnius, April 16th, 2004
• Raoul Berglund, FASF, CEFA

2
AGENDA

• Introduction to the legislative background
• International framework
• Definition of ALM
• EU directives and ALM
• IAIS Supervisory Standard 4
• The approach adopted in Finland
• Best practice
• The liability report
• The investment policy
• Applied ALM techniques

3
AGENDA (cont.)

• Organisation of ALM
• Supervisory issues
• The future
• IAS/IFRS
• Solvency II
• A simple ALM example

4
1. Introduction to the legislative background
5
International framework

• Definition of ALM
• Asset Liability Matching gt Asset Liability
  Management
• There is no unique definition of ALM. The
  following definition is given by the Society of
  Actuaries
•   
• Asset Liability Management is the on-going
  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.

6
International framework (cont.)

• EU directives and ALM?
• No specific reference to ALM exist.
• However, indirectly some basic ALM concepts are
  addressed.
• Requirement to cover the technical provision by
  assets (Directives 2002/83/EC article 20 and
  92/49/EEC article 15)

7
International framework (cont.)

• The four pillar requirement (Directives
  2002/83/EC article 22 and 92/49/EEC article 20)
•  
• The assets covering the technical provision
  shall take account of the type of business
  carried on by an assurance undertaking in such a
  way to secure the safety, yield and marketability
  of its investment, which the undertaking shall
  ensure are diversified and adequately spread.
•  
• Categories of authorised assets to cover the
  technical provision (Directives 2002/83/EC
  article 23 and 92/49/EEC article 21)

8
International framework (cont.)

• Rules for investment diversification (Directives
  2002/83/EC article 24 and 92/49/EEC article 22)
• The home Member State shall lay down detailed
  rules fixing the conditions for the use of
  acceptable assets.
•  
• Assets covering technical provisions must be
  diversified and spread in such a way as to ensure
  that there is no excessive reliance on any
  particular category of asset, investment market
  or investment.
•  
• Investment in particular types of asset which
  show high levels of risk, whether because of the
  nature of the asset or the quality of the issuer,
  must be restricted to prudent levels.
•  
• etc.

9
International framework (cont.)

• IAIS Supervisory Standard 4 (Supervisory Standard
  on Asset Management by Insurance Companies)
•  
• The Board of Directors should be responsible
  for the formulation and approval of the strategic
  investment policy, taking into account of the
  analysis of the asset/liability relationship, the
  insurers overall risk tolerance, its long-term
  risk-return requirements, its liquidity and its
  solvency position.
• (Of interest is also the IAIS guidance paper
  Stress Testing By Insurers)

10
The approach adopted in Finland

• The EU Directives have been implemented as such
  (the four pillar requirement etc.).
•  
• A separate decree on assets covering the
  technical provision has been giving (legislators
  view on asset diversification).
• - Very detailed gt deep complexity
• - Non-flexible gt do not cope very well with
  new complex investment products and investment
  strategies.
•   The Finnish Insurance Company Act stipulates
  that every insurance company must have an
  investment policy and furthermore that the
  obligation of the Insurance Supervisory Authority
  (ISA) is to give regulations concerning the
  contents of the investment policy.

11
The approach adopted in Finland (cont.)

• As the directives, the current Finnish
  legislation or regulation contains no specific
  reference to ALM.
•  
• The Insurance Companies Act, however, indirectly
  stresses some basic ALM concepts.
•  
• Factors that influence the solvency of an
  insurance company must be managed with respect of
  safeguarding insurance consumers interest by
  taking into account possible variation of
  earnings and expenses and other relevant factors.

12
The approach adopted in Finland (cont.)

• This statement can be taken, however not
  officially done so by the legislator, as a
  requirement of implementing a comprehensive ALM
  approach.
• ISAs regulation requires that the appointed
  actuary must to the Board of Directors give a
  written statement about the requirements that the
  profile of the liabilities impose on the assets.
•  
• The appointed actuary must also give a written
  statement to the Board of Directors that the
  investment policy fulfils the requirements
  imposed by the liabilities.

13
The approach adopted in Finland (cont.)

• The basic ideas with the appointed actuarys
  statements are that the first statement reflects
  the bridge from liabilities to assets and the
  second one the bridge from assets to liabilities.
  
•  
• The reports given by the appointed actuary
  together with the investment policy approved by
  the Board of Directors forms an ALM policy

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2. Best practice
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The liability report

• Life insurance liability usually have a longer
  maturity, contains more guarantees and embedded
  options and tend to be more dependent on economic
  and financial market performance than non-life
  insurance liability.
• Therefore the actuarial report of the liability
  is of greater importance in life insurance.
• The best reports do not only consider what
  requirements the liability as such impose on the
  investment activity, but also the enterprise wide
  factors and objectives that pass requirements on
  the investment activity through the existence of
  liability.

16
The liability report (cont.)

• Segmentation of liability by
• Product
• Product design can have material effect on ALM
• Maturity
• Expected maturity or contractual maturity?
• Ability to surrender (life)
• Sticky liability vs. floating liability
• Currency
• Inflation
• Claims inflation (non-life)
• Inflation linked benefits (life and non-life)
• Technical interest rate
• Guaranteed interest rate (life)
• Discounting (non-life)
• Other guarantees

17
The liability report (cont.)

• Embedded options (life)
• Guaranteed minimum payoffs unaffected by changes
  in market interest rates
• Option to change a fixed rate policy to a
  unit-linked policy for a certain period
• etc
• Required return
• Technical interest rate
• Bonus strategy (life)
• Shareholders required return
• Premium reductions (non-life)

18
The liability report (cont.)

• Cash flow projections
• Undiscounted prudently estimated contractual
  projections (traditional assessment)
• Market value projections (fair-value like
  assessment)
• Solvency
• How much investment risk can be taken without
  jeopardising insurance consumers interest?
• Prudent management of an insurance company
  includes setting own risk tolerance and solvency
  limits, which should be higher than the statutory
  ones and in accordance with a long run continuity
  of the company.

19
The liability report (cont.)

• Liquidity requirements
• Under normal circumstances liquidity is no
  problem (upfront premiums).
• How much should at least be kept in money market
  in order to smoothly cover expenses and unusual
  market behaviour that might occur?
• Assets that cover the technical provision
• The growth of liabilities vs. available assets to
  cover the liabilities
• How much investment risk can be taken?

20
The liability report (cont.)

• Diversification of assets
• The statutory rules
• Elimination of possible risk concentration
• Assessment of the most significant liability
  risks
• Classification of risks
• Uncertainty of made assumptions

21
The investment policy

• According to the latest regulation by the ISA the
  Board of Directors is responsible for formulation
  and approval of the investment policy and it
  should cover at least the following areas
• General principles for the investment activity
• objectives of the investment activity
• the investment return in the short-term and in
  the long-term
• the principles of diversification, liquidity and
  counter-party risks
• the principles for the use of derivatives
• the board of directors should annually evaluate
• the risks involved in the investment activity
• the requirements that the profile of the
  liabilities impose on the investment return,
  liquidity, currency position
• overall risk tolerance in the short and long-term
  
• the development of the solvency

22
The investment policy (cont.)

• Establishment of limits applied to the investment
  activity
• The board of directors must in line with the
  decree on assets covering the liabilities decide
  the exposure limits for both individual
  securities and different asset categories.
• Cumulative limits for different risks must also
  be established, which includes for example risks
  taken by derivatives.
• Guidelines for the use of possible hedging
  strategies as part of the general portfolio.
• The management of the currency position must also
  be included.

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The investment policy (cont.)

• The organisation of the investment activity,
  delegation of power and reporting
• The board of directors must decide which of the
  investment decisions are delegated and which of
  them are not.
• The board of directors should also see to that
  the reporting of the investment activity is
  frequent and done in writing.
• The investment policy must also contain a
  clarification of the use of external asset
  management service.

24
The investment policy (cont.)

• The investment policies typically pay extra
  attention to the EU four-pillar requirement
• Safety
• The volatility of the investment risk should be
  kept within available solvency buffer imposed by
  the solvency requirement or by the insurance
  companys own target.
• The safety requirement on assets and the required
  return from assets covering the technical
  provision must be kept in balance.
• An assessment of the insurance companys risk
  tolerance with respect of both the solvency and
  the assets that cover the technical provision
  should be made.

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The investment policy (cont.)

• Yield
• The basic yield requirement (average guaranteed
  interest rate, average discount rate etc.)
• The yield requirement set by the competition
  (bonuses, premium reductions etc.)
• The yield requirement set by the shareholders
• The yield requirement and the safety requirements
  must be coordinated.
• Liquidity
• Liquidity of assets (limitation for non-liquid
  assets)
• Liquidity requirement set by the technical
  provision (unfavourable claims development)

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The investment policy (cont.)

• Diversification  
• Avoiding risk concentration
• Currency position
• The regulatory principles of asset
  diversification
• The asset allocation should be dependent on the
  level of solvency and the profile of the
  liability.

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Applied ALM techniques

• Conventional strategies (deterministic approach)
• Segmentation of products
• Specific assets back specific products
• Gap buckets
• Matches assets and liabilities by maturity.
• Duration immunisation strategies
• Seeks to match duration of asset and liability
  cash flows.
• Inflation immunisation strategies
• Seeks to match the inflation risk of assets and
  liabilities.
• Cash flow matching
• Seeks to exactly match asset and liability cash
  flows.
• Efficient asset portfolio (mean-variance theory)
• Classical minimum variance asset portfolio
  optimisation with different constraints
  (allocation, shortfall, liability growth etc.)

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Applied ALM techniques (cont.)

• Modern strategies (commonly a stochastic
  approach)
• Cash flow analysis
• Seeks to analyse the uncertainty of asset and
  liability cash flow estimates.
• Duration and convexity analysis
• Seeks to analyse the sensitivity of assets and
  liabilities to interest rate changes (beyond
  parallel shift - key rate sensitivity).
• Stress testing
• What if analysis.
• Value at Risk
• Tries to capture the loss (income statement,
  investment etc.) for a given confidence interval
  over some time period.
• Expected shortfall (conditional tail expectation)
• Tries to capture the expected loss (income
  statement, investment etc.) for a given
  confidence interval over some time period.
• Value creating strategies
• Tries to increase economic value (the absolute
  amount of value added to shareholders over a
  period of several years.)

29
Applied ALM techniques (cont.)

• Efficient economic value strategies
• Seeks the efficient (minimum variance) economic
  value asset strategies given a company's
  liability profile and business plan. (The
  evaluation is commonly based on consistent
  valuation of asset and liabilities).

Economic Value
Minimum variance strategy
Same risk higher economic value
Current strategy
Same economic value less risk
Risk
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Applied ALM techniques (cont.)

• Stochastic simulation
• In many cases the complex nature of the products
  of an insurance company mean that the ALM
  objectives cannot be solved using a deterministic
  formula approach.
• Pre-defined scenarios do not help to quantify the
  level of risk and some less obvious dangerous
  scenarios may be overlooked. Projecting the
  companys results based on a large number of
  stochastic economic simulations therefore add
  extra value.
• The most comprehensive models allow for the
  interaction between assets and liabilities and
  the ability of the company to take corrective
  action by changing for instance the asset
  allocation or bonuses in adverse scenarios.

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Applied ALM techniques (cont.)
Assumptions
Parameters (mortality etc.)
Parameters (asset values etc.)
Stochastic economic scenarios producing (market
consistent) economic variables
Economic link
Liability projections producing simulations of
actuarial strategies
Asset projections producing simulations of asset
mix strategies
Multi-period decisions
Range of possible outcomes to be measured
Analysis of simulations in line with objectives
set
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Organisation of ALM
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Old Approach

• Business decisions at functional levels
• The actuarial department focuses on the
  liability side of the operations and investment
  department on the risk and rewards of alternative
  asset strategies and asset classes.
• The modern way is to integrate the various
  aspects of both sides into an asset-liability
  management with the goal to achieve financial
  objectives.

34
Modern Approach

• Board of Directors / Top management
• Strong commitment and involvement
• Promote risk management culture
• Statement of principles and objectives with
  respect of ALM should be documented and approved
  by the Board of Directors

35
Modern Approach (cont.)

• Recourses should be allocated to ALM
• ALM committee (investment committee?)
• Investment and actuarial matters around the same
  table
• Roles and responsibilities should be well defined
• Asset performance measurement vs. financial
  objectives.
• Top management should be present
• Strategic and tactical aspects
• Meetings should be held frequently (at least
  monthly) and documented

36
Modern Approach (cont.)

• Independent ALM group or function
• Technical aspects of ALM
• Assumptions and model architecture should be
  documented well
• Responsible for doing the projections
• Education requirement
• During the recent years the sophistication of ALM
  has increased
• ALM requires continuous studying, which should be
  required and promoted

37
Modern Approach (cont.)

• Reporting
• Risk management committee
• Top management
• Board of directors
• Frequency of determination (observed)
• Deterministic models usually annually (in
  connection with formulating the ALM-policy
• VaR and expected shortfall weekly to quarterly
  (solvency and cover of technical provision)
• Stress testing monthly to quarterly (solvency and
  cover of technical provision)
• Stochastic scenario testing quarterly to annually
  (depends on market behaviour)

38
Supervisory issues
39
Regulatory aspects

• How should ALM be required? Different approaches
  exist
• Set a general requirement to perform ALM
• Wait and see how market practise develops
  strategy
• The development tends to be slow. Companies tend
  to apply the same wait and observe strategy.
• A highly flexible approach. Insurance companies
  can develop their approach freely without
  constraints.
• Tends to create set of more variable approaches.
• Set a general requirement to perform ALM
  companied with guidelines
• An active role by the supervisors in setting
  market practise.
• Commonly the next step after some market practise
  have been formed.
• To some level it will harmonise the ALM
  approaches taken by the insurance companies.
• Requires some knowledge from the supervisors.

40
Regulatory aspects (cont.)

• Set a general requirement to perform ALM
  companied with a set of minimum requirements (and
  a guideline)
• Taking the earlier approach on step further.
• Set a detailed requirement to perform ALM with a
  rather strict set up.
• Dangerous!
• Is there a unique ALM approach that would be
  suitable for all companies?
• Smaller companies can get by with less
  sophisticated methods.
• Risk of driving the insurance companies all
  together towards a sub optimal solution
  (destroying value).
• Requires extremely deep knowledge from the
  supervisors and the legislators.

41
Supervision of ALM

• Holistic supervisory approach is needed which
  places significant emphasis on the
  responsibilities of the top management.
• Quality requirement of internal control and risk
  management should be set.
• Supervisors should have the power to assess the
  quality of the ALM and its processes.
• There is a need for forward looking supervision.
  Supervisors should therefore promote the use of
  different ALM techniques.

42
Supervision of ALM (cont.)

• Insufficiently flexible supervisors could quickly
  suffocate financial innovations in a rapidly
  changing environment.
• However, in areas where a wide range of practise
  exist, it might be desirable to have a narrower
  range of practise.
• The applied ALM principles should be sound
• Practices that may be theoretically unsound
  should be identified.
• Supervisors should be able determine the correct
  or a more preferable approach.

43
Supervision of ALM (cont.)

• There is a need for guidelines both for insurance
  companies developing ALM systems and for the
  supervisors to be able to assess the
  appropriateness of the systems.
• To be effective the supervision of ALM requires a
  substantial amount of effort and expertise.

44
Supervision of ALM (cont.)

• In order to have a holistic and effective
  supervision of ALM there is a need for a
  supervisory ALM-team, with expertise in at least
• investment,
• insurance mathematics,
• statistics,
• economics,
• IT and
• internal control.

45
Supervision of ALM (cont.)

• However, very often the supervisors are
  under-resourced, both financially and in terms of
  experienced personnel
• There is a need to share the knowledge of ALM
  practices among practitioners and foreign
  supervisors.
• Does not include specific strategies for managing
  the exposure or company confidential information
  and in-depth technical solutions.

46
The future
47
IAS/IFRS

• Key changes compared to the current practise
• Discounting of liability by risk-free market
  interest rates that reflect the time value of
  money (risk-free interest rate curve).
• Insurance liabilities are measured as the
  expected present value of all future cash flows
  arising from the contractual rights and
  contractual obligations associated with the
  insurance contracts.
• Insurance liabilities should always reflect risk
  and uncertainty and it should preferably be
  reflected in the cash flows.

48
IAS/IFRS (cont.)

• Thus,
• in principle the method should be a stochastic
  approach (probability-weighted arithmetic average
  of different cash flows at a given date),
• deterministic methods might, however, give
  results that fall within an acceptable range ,
• options and guarantees contained in contracts
  must be valued (as already required by the
  existing EU directives),
• new calculation methods must be excepted and
  applied replicating portfolio, simulation etc.

49
IAS/IFRS (cont.)
Replicating portfolio of the assets

Technical provision according to current praxis
Market interest rate
50
IAS/IFRS (cont.)
Replicating portfolio of the assets

Technical provision according to IAS
Market interest rate
51
Solvency II

• Development of a new more risk-sensitive system
  for assessing the overall solvency of an
  insurance undertaking.
• A risk oriented approach, which encourages
  insurance undertakings to measure and manage
  their risks
• Should take into account international
  developments (IASB, IAIS, IAA)

52
Solvency II (cont.)

• Three pillar system
• I.Quantitative financial requirements
• regulatory capital requirements
• Internal models
• etc.
• II. Qualitative tools and strengthened
  supervisory review process
• Principles of internal control
• Principles for sound risk and financial
  management
• Principles for Asset-liability management
• Harmonised supervisory review process
• Harmonisation of early-warning indicators and
  reference scenarios for stress tests
• etc.
• III. Market transparency and disclosure

53
A simple ALM example

• Assumptions
• Current market value of assets equals market
  value of liabilities
• Assets are thus sufficient to economically hedge
  liabilities
• The cash flows from assets and liabilities are as
  follows

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A simple ALM example (cont.)
Time period
55
A simple ALM example (cont.)

• Thus,
• there exist a significant reinvestment risk,
• the asset duration is shorter than the liability
  duration.
• Assume the following hedging strategy
• A tailored overlay portfolio of interest rate
  swaps that immunizes the asset/liability cash
  flow from any changes in level or shape of the
  interest rate curve.
• The swap extends the duration of the asset
  portfolio and sets it equal to the duration of
  the liability.
• The initial effect on the solvency position is
  zero, since at inception the value of the swap is
  zero.

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A simple ALM example (cont.)
Hedged portfolio
Time period
57
A simple ALM example (cont.)

• In a fair-value world, if
• interest rates increase
• the unhedged portfolio would increase the
  solvency margin and
• in the hedged portfolio the solvency margin would
  be unaffected.
• interest rates decrease
• the unhedged portfolio would decrease the
  solvency margin and
• in the hedged portfolio the solvency margin would
  be unaffected.
• Hedging is rewarded.
• The reinvestment risk in the unhedged portfolio
  should be taken into account in the solvency
  requirements.

58
A simple ALM example (cont.)

• According the current accounting praxis, if
• interest rates increase
• the unhedged portfolio would decrease the
  solvency and
• in the hedged portfolio the solvency would
  decrease even more.
• interest rates decrease
• the unhedged portfolio would increase the
  solvency and
• in the hedged portfolio the solvency would
  increase even more.
• Hedging will not give any reward, on the contrary
  it might punish.
• The asset profile has no effect on the current
  solvency requirement.

59
A simple ALM example (cont.)

• Conclusions
• The current accounting praxis and the solvency
  system does not create proper incentives for ALM.
• The current solvency requirement is clearly
  incompatible with the fair-value world.
• The results of the Solvency II project will be of
  utmost importance for the future development of
  ALM (regardless of the accounting praxis).