Raoul Berglund, Insurance Supervisory Authority Finland

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

1. Introduction to the legislative background International framework

– Definition of ALM– EU directives and ALM– IAIS Supervisory Standard 4

The approach adopted in Finland

2. Best practice The liability report The investment policy Applied ALM techniques

3

AGENDA (cont.)

3. Organisation of ALM

4. Supervisory issues

5. 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” => 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


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


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


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 insurer’s 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 (legislator’s view on asset diversification).

- Very detailed => deep complexity - Non-flexible => 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 consumer’s interest by taking into account possible variation of earnings and expenses and other relevant factors.

12


This statement can be taken, however not officially done so by the legislator, as a requirement of implementing a comprehensive ALM approach.

ISA’s 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 basic ideas with the appointed actuary’s 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”

14

2. Best practice

15

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


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) Shareholder’s required return Premium reductions (non-life)

18


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

consumer’s 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


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


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

º the risks involved in the investment activityº the requirements that the profile of the liabilities impose on the investment

return, liquidity, currency positionº overall risk tolerance in the short and long-term º 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.

23


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 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 company’s 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 company’s risk tolerance with respect of both the solvency and the assets that cover the technical provision should be made.

25


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)

26


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.

27

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.)

28

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).

Risk

Economic Value

Current strategy

Minimum variance strategy

Same risk higher economic value

Same economic value less risk

30


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 company’s 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.

31


Assumptions

Stochastic economic scenarios producing (market consistent)

economic variables

Parameters (mortality

etc.)

Liability projections producing

simulations of actuarial strategies

Asset projections producing

simulations of asset mix strategies

Range of possible outcomes to be measured

Analysis of simulations in line with objectives set

Parameters (asset

values etc.)

Economic link

Multi-period decisions

32

Organisation of ALM

33

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


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


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 it’s 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


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


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


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.)

Market interest rate

€

Technical provision

according to current praxis

Replicating portfolio of the assets

50

IAS/IFRS (cont.)

Market interest rate

€

Technical provision

according to IAS

Replicating portfolio of the assets

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 systemI.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:

54

A simple ALM example (cont.)

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Asset Cash Flow Liability Cash Flow Time period

55


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.

56


1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Asset Cash Flow Liability Cash FlowTime period

Hedged portfolio

57


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


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


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).

Documents

Raoul Berglund, Insurance Supervisory Authority Finland