Sanjeev Pujari

Assets & Liabilities under various market scenarios

ASSET LIABILITY MANAGEMENT

Agenda

Introduction Economic outlook & market fluctuationBusiness LinesClient behaviour and Management ActionAlternative strategiesIndian Business Environment

Introduction Investing to meet liabilitiesRisk is “not” the same for all investorsLiabilities play as much a part of the asset allocation decision as the assetsA-L risk is leveraged in the sense that values of A or L tend to be greater than the value of the capital; modest fluctuations can result in reduction in capital

Introduction

Theory of immunization – equating modified duration of assets to that of the liabilities (Redington,1952)The notion of “Convexity” gave immunization a new lease of lifeStochastic investment modelling / solvency testing (Wilkie,1986)Advancement of computer powerAsset/liability models of asset allocation techniques

Introduction

Conventional view of asset allocation focuses on beating some external benchmarkModern theory optimal asset allocation for insurance companies focuses on liabilities

Unique to each companyConsistent with corporate finance theory in maximizing value to shareholdersAccounts for specific risks of policies written

Opt

imal

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et A

lloca

tion

Assets

Insu

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e Li

abilit

ies

Policies

Modern View

Introduction

Strategic ALM

Introduction-Asset liability modelling

Cash flow projections of assets and liabilities; probability distribution of asset return if approach is stochasticDeterministic modelStochastic approach

Random variables/probability distributions of correlated market factorsLiability values based on discounting cash flows at the then current market rate Simulations

Deeper insights: construction of risk/reward profile & optimal asset mixWider application e.g. risk based capital

Introduction-ALM: Process Overview

Policy holder and Asset Data

Asset Model Liability Model

Define Purpose

Output

Introduction - Asset liability modeling

Risk reward point is plotted & risk/reward profile curve is drawnAt relatively lower guaranteed rate, the curve looks like a traditional ‘efficient frontier’ as the nature of liabilities becomes relatively unimportantAsset-Asset model to Asset-Liability Model

Economic outlook & Market fluctuation

Typical financial risk in a life company –duration gap between assets and liabilitiesAssets would typically have a shorter duration than the liabilitiesFixed income assets valued at lower market value or at costExposure to falling interest rates, but gains in A/L position if interest rates rise

Economic outlook & Market fluctuation – Indian stock market

Economic outlook & Market fluctuation – Indian Debt Market Yield

Economic outlook & Market fluctuation

Considering extreme market movements –shock/jump scenarios – tail of the distributionAdding jump models to lognormal models for equity investmentModelling shocks when markets are already low – introducing moderation through dampeners (e.g. shock dampened by any extent of fall from the average level in the last 3 months)

Economic outlook & Market fluctuation

If Dow Jones would have followed a lognormal distribution

It would have moved 3.4% in a day 58 times last century – it did 1000 timesIt would have moved 4.5% in a day 6 times last century – it did 366 timesIt would have moved 7% in a day 1time last century – it did 48 times

Benoit Mandelbrot

Economic outlook & Market fluctuation

Effect of introducing shocks in a lognormal equity modelBlack Swan events

Merton JumpModel

Economic outlook & Market fluctuation

Merton Jump Model

Client behavior & Management action

Cash flows relating to existing policyholders are subject to policyholders’ future decisions about if and when they would surrender/partially withdraw or exercise other policy optionsRational behavior of policyholder would normally have the most disadvantageous effect for the insurerHowever, the extent of rational behavior is limited

Difficult to assess

Client behavior & Management action

The following are some considerations –Benefits/benefit guarantees carriedPattern of surrender chargesInterest rate scenario and other economic factors

Client behavior & Management action

Company’s response to instant/sharp shocksCompany would adjust the levels of discretionary payments it would makeTerminal bonuses would change as market condition changes, regular bonuses would respond much slower; subject to smoothing rules in PPFM/PRE/TCFInterest rate crediting processChange investment strategy; asset liability management objectivesCash/Surrender values – based on changed conditions

Business Lines

Guaranteed Products/Guaranteed rate products: Need to match durationGuarantee plus option for more: With Profits products

Embedded options above guaranteed benefitsAsymmetry in the product – guarantee is small (in the money) & hence expectation of profit sharing

Investment StrategyMinimize risk of guarantee biting – matchMaximize possibility of higher bonus – assets invested shorter than liability (duration gap): exposure to falling interest rate but higher bonus as interest rates rise

Administered rate products

ALM – A Life office case study

Market value analysis of asset and liability –choosing a suitable strategic asset allocation for a life office

Hedge asset liability mismatch thereby reducing interest rate exposure in the balance sheet

ALM – A Life office case study

Liability cash flows (up to 20 years) with guarantees ranging from 3% to 5%

Net liability cash flows have modified duration of 22 years

ALM – A Life office case study

Assets constitute bonds, bank deposits and equities

Modified duration of assets 6.4

ALM – A Life office case study

Assume parallel shift in yield curveThe net asset shrinks as interest rates decrease as the duration of liability is higher (duration gap) 175 bps decline in interest rate brings the net assets to zeroLiabilities are more convex than the assets – net assets decreases faster with decreasing rates175 bps shift (fall) ~ 1.5 std dev event, we can calibrate risk management strategies with zero net asset consistent with a 2.0 std dev event

ALM – A Life office case study

ALM – Hedging strategy

Decrease in interest rate sensitivity in the balance sheet – enter into a spot starting receiver swap (10 years)

Increase in asset duration to 11 yearsRates now have to decline by more than 275 bps to bring market value buffer to 0An improvement of 100 bpsLoss if interest rates increase

ALM – Hedging strategies

Duration gap in assets & liabilities – a typical financial risk in life companies; assets will have shorter duration than liabilitiesDuration gap exposes company to falling interest rates but net asset position gains in rising interest scenario

Scarce longer duration assetsFavored by regulatory regimes when liabilities are valued at statutory rates and assets are static on the upside (lower of market value & cost) – shorter duration exhibit less price sensitivity to interest ratesPolicyholder expectation to participate in higher bonuses if interest rates rise

With Profit Product

Sensitivity of the bonus option is opposite to that of the guaranteed benefitDuration of the combined liability is shorter than that of the guaranteed benefitCombined liability would show convexity i.e. duration increases when interest rates fall and decreases when interest rates riseDrastic fall in interest rates – value of bonus option shrinks – need to lengthen duration of investmentsSubstantially rising interest rates – value of bonus option rises – need to shorten duration of investments

ALM – Hedging strategies

Dynamic duration strategy : When interest rates fall, it is essential to lengthen duration of investment portfolio; shorten it when rates rise -convexity

Most appropriate duration for every interest rate environment – manage convexity

ALM – Hedging strategies

Dynamic hedging: Rebalancing of portfolio by duration at certaintrigger points

Adjustment of duration of bonds by sale and purchaseUse of swapsTransaction cost higher due to constant rebalancing of assetsP&L volatility through profit and loss recognitionManagement attention

Using financial instruments: Using interest options to hedge against convexity – lengthen the duration of the combined portfolio as interest rate fall

Reinvestment risk can be hedged with ‘receiver swaption’introducing the precise convexity (swaptions have higher +veconvexity than bonds) required to protect when interest rates decline

ALM – Hedging strategies

Convexity

Indian Business Environment

Product development:Single premium guaranteed bondsParticipating/With Profits/Guaranteed addition productsUnit-linked productsUnit-linked products with guarantees

Market fluctuations:Ever-changing interest ratesVolatile capital markets

Indian Regulatory Environment

Investment is restricted:Maximum limits on equity investments; e.g. 35% in life funds and 60% in pensions/annuity fundsInvestment in derivative instruments is restrictedMatching instruments of sufficiently long durations (beyond 10-15 years) not available

Professional Guidance

Consistency between valuation of assets and liabilitiesConsideration be given to the nature and term of assets and liabilities and relationship between the twoResilience testing to be done under all foreseeable circumstances that might affect the financial position of the companyInvestment policy should be appropriate to the nature and term of the policyValuation basis should be consistent with PRE even under resilience scenario

ALM Challenges in India

Practical issues:Lack of expertiseData unavailabilityInvestment limitationsAvailability of instruments

Communication with management:Need for ALM?Board’s understanding?

Thank you