Session 3a – Asset Liability Management Strategies

Zachary Brown, CFA, FRM, PRM

9/7/2016

Asset Liability Management Strategies – SessionZACHARY Z. BROWN, CFA, FRM, PRMPortfolio Manager, MillimanSeptember 1st, 2016

Measuring Investment Success• Asset Management

• Metrics: Rate of return, Sharpe Ratio, Alpha • Benchmarks: Market indices, Peer Group analysis

• These measures only consider the assets; they don’t take into account the liabilities

2

9/7/2016

Sequence of Returns Effect• The optimal portfolio for a buy and hold investor will

focus on performance over a long period of time

3

The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio.

Sequence of Returns Effect• Buy and hold investors can afford to take short term

losses as long as the market eventually recovers

4

The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio.

9/7/2016

Sequence of Returns Effect• Investors with large liabilities can’t afford to ride out

the storm

5

The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio.

Measuring Investment Success• Equitable – US life insurance company in the 1980s

• Guaranteed Interest Contracts (GICs) – Guaranteed 16% rates for up to 10 years

• Equitable invested in short term bonds• Interest rates fell, Equitable was demutualized and sold

6

9/7/2016

Measuring Investment Success• McKinsey & Company, 2015• “While liability risk management and investment

skills both help drive earnings, risk management is the main driver of performance differentiation for value creation in life insurance in China.”

• “Further, based on similar research across life insurance markets globally, we believe that this balance will shift even more towards liability risk management excellence as the Chinese economy matures.”

7

Asset Liability Management (ALM)• Take into account both assets and liabilities when

making decisions• Who uses ALM?• “Financial theory offers no good reason for making a

distinction between ALM as practiced by banks, insurance companies, or pensions”

• CFA Institute, 2013

• History of ALM Strategies

8

9/7/2016

Dedication – 1970s• Exact matching of a stream of future cash flows• Rigid, inflexible, and more expensive to implement

as interest rates declined from 1982 onward

9

Immunization – 1980s• Match the interest rate sensitivity of the liability in

present value terms• Duration: Measure of how value changes as interest

rates change

10

9/7/2016

Problems with Duration• Only works for small changes in interest rates

• Convexity: Measure of how Duration changes as interest rates change

• Only works for parallel shifts in interest rates• Key Rate Duration: Duration for specific segments of the

interest rate curve

11

Problems with Duration - Optionality• “In order to keep the competitiveness in the

marketplace, almost all insurance companies offer embedded options in their products”

• Society of Actuaries, 2003

• Floor guarantees, prepayment risk• “Prepayment risk can undermine the best

asset/liability management strategy if it is grounded entirely on duration”

• Center for Insurance Policy and Research, 2012

12

9/7/2016

Surplus Optimization – 1990s• Financial Accounting Standards allowed pensions to

use return on assets to offset pension liabilities • Incentive to invest heavily in equities• “The equity bear market that hit in 2000-2002

became a pension tsunami” • CFA Institute, 2013

13

Surplus Optimization

14

9/7/2016

Current Best Practices• Hedging• Decompose liabilities into risk factors• Greeks:

• Delta, Gamma, Rho, Vega

• Complex liability modelling• Every policy sold to investors vs. model points• Dynamic policyholder behavior

• Market Scenarios: Equity markets, interest rates, volatility surfaces

15

Current Best Practices• Baseline: Deterministic Scenario• The average profit over all scenarios is NOT equal to

the profit in the average scenario

16

SOURCE: The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty by Sam L. Savage, with illustrations by Jeff Danziger.

9/7/2016

Current Best Practices• Stress testing, sensitivity analysis

17

• Stochastic Scenario Analysis• Scenario generator: create a large number of scenarios• Computing power: computationally intensive calculations

Using ALM Tools Holistically• ALM Tools and strategies can be used in all stages• Product Design

• Create products that are easier to hedge• Reinvestment risk: Floating rate products• Equity market risk: Managed Risk Funds

• “Nearly all of the top variable annuity living benefit writers require Vol Funds to be selected as investment options”

• Insured Retirement Institute, 2015

18

9/7/2016

Derivatives• Tools to implement ALM Strategies: Swaps, options,

futures, forwards• “The notional value of derivatives held by the

insurance industry increased 8.6% from the previous year to about $2.02 trillion.”

• NAIC, 2016

• Flexible, low transaction costs, generally good liquidity

• Basis risk, Counterparty risk

19

Performance Attribution

20

9/7/2016

Derivatives Market in China• First stock index futures market - 2010• Five-year government bond futures - 2013 • Industry groups likely to seek approval to launch a

CDS market soon• “Yet the new rules have also made life more difficult

for hedgers.”• Financial Times, 2015

21

Derivatives Market in China

22

9/7/2016

The Future of Risk Management• Demographics: as populations age, risk management

becomes more important• “The analysis reveals that the primary difference

between China’s higher- and lower-performing life insurers is skill in managing liability risk.”

• McKinsey & Company, 2015

23