Strategic asset allocation: case study by Aspen Re – using ...€¦ · Strategic asset allocation: case study by Aspen Re – using the internal model to change asset strategy Dr

Strategic asset allocation: case study by Aspen Re – using the internal model to change asset strategy

Dr Marcus Foley, Aspen ReSam Worthington, Towers Watson

27 September 2013, Brussels

© 2013 Towers Watson. All rights reserved.

Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

Agenda

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Overview of strategic asset allocation (SAA)

Aspen: a case study of SAA

Overview of SAA



Why are insurers revising their strategic asset allocation now?

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Profitability and risk management (on-going requirement)

Risk management Achieving best practice risk management

Returns Improving risk adjusted returns more generally

Stakeholder demand Improve shareholder ROE and reduce/maintain policyholder premiums

Competition React to competitors increasing their investment returns

Diversification Asset risk is a good diversifier of insurance risk (eg natural cat risk)

Catalysts for change

Regulatory Discounting liabilities, recognising diversification effects, ‘use test’

Investment markets Seek out alternative sources of return the current in low bond yield environment



Capital teamInvestment teamBoard / executive management

Calibrate model for SAA

Define SAA scope and constraints

Analysis and recommendations Implementation

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§ Agree to review SAA

§ Define risk appetite*

§ Define opportunity set, investment beliefs and general constraints

§ Decide key risk/return metrics to use

§ Decide SAA approach

§ Establish in-house views on asset risk and return metrics

§ Calibrate ESG and asset returns to your views

§ Implement investment constraints

§ Run model and output key risk/return stats

§ Overlay qualitative investment analysis

§ Scenario analysis

§ SAA recommendations with clear rationale

§ Benchmark results with independent views and stress tests

*Note defining risk appetite is a substantial project in its own right

§ Agree SAA changes

§ Buy or build implementation ability

§ Manager selection

§ Negotiating terms

§ Review management information dashboard

§ Transition to new SAA

§ Dynamic asset allocation framework?

§ Periodic SAA review (i.e. annually)

What are the steps for implementing SAA?

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Aspen: a case study of SAAScope and constraints



Background


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Background to Aspen

• Bermudian domiciled specialty P&C insurer and reinsurer• $8mm in investible assets• More than 800 people worldwide

Capital modelling team

• Capital model 10 years old• Built to inform business strategy

Board commissioned SAA review in late 2012 - two approaches1. Major investment house used their standard SAA approach2. Aspen’s capital modelling team used internal model with Towers Watson’s

SAA model


Overview of work


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Board objectivesl Long term: to increase the group’s book valuel Short term: assess how to spend surplus capital

l Share buybackl Increasing investment risk appetite

External economic considerations• Historically low interest rates• Low yield on investment grade fixed income assets• Recent yield rebounding of sub-investment grade assets from credit

Internal considerationsl Capital constraintsl Balance sheet volatilityl Aggregation of asset and insurance risk


Asset portfolio before SAA

Investment holdingsGovernment bond, agency 26%Investment grade credit 30%RMBS 15%High yield, CMBS, ABS+ Munis, derivatives 4%Equity 3%Cash 22%

High quality, fixed interest portfolioInterest rate duration around 2 years net of IR swap

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Aspen: a case study of SAAModelling and analysis



A comparison of two SAA approaches

Analysis of last 3 years of returns

Volatility

Total return only

Using government bond proxy

From internal, asset manager and

Towers Watson forecasts

Capital requirement and volatility

Yield and total return

Using internal model projected liabilities

Investment house Aspen’s internal team

Assumed to be GaussianCaptures non-linear

dependency between assets and liabilities

ASSET RETURN CALIBRATION

RISK MEASURE

RETURN MEASURE

LIABILITIES MODELLED

DEPENDENCIES

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Investment house SAA summary


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Modelling analysis conclusionsl Significant diversification between fixed income instruments across the

credit spectruml High expected returns for credit (extrapolate rebound since 2008)l Equity unattractive due to its volatility

Recommendation: a significant switch from high rated corporates to sub-investment grade credit

Weaknesses

l Risk aggregation between assets and liabilities poorly capturedl Credit expected returns over-inflated


-600

-500

-400

-300

-200

-100

-

100

200

300

400

1 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

Expe

cted

Pro

fit ($

m)

Percentile

Breakdown of Asset Risk for Indicated Percentiles

Credit Risk Equity Risk Interest Rate Risk

Aspen’s modelling results: asset risk contribution to total risk


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l Interest rate risk is a material risk driver across the distributionl Tail risk is most strongly affected by credit risk


Comparing investments: capital impact


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Credit assets increased capital requirements most

Equity had the highest long term expected return for a high level of risk


Comparing portfolios: total return v RoE


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Most capital efficient investment options:l Invest in equity (high return and medium capital impact)l Switch from credit (rather than cash)l Invest in agency RMBS (medium return but low capital impact as capital is

insensitive to interest rate risk)


Qualitative analysis: stress tests


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l Assessment of balance sheet volatility (infrequent but regular risk)l Determined maximum threshold for equity investment = 5%l Validation of quantitative model results = board comfort l Intuitive communication of risk

Assumptions Portfolio impact ($m)

Scenario Period Equity return Yield curve Spreads Base 5% Cash to equity

5% A-rated to equity

10% from treasuries and

A-rated to agency RMBS

and equity

Base 6.7% <+50bps zero 107 134 132 137

Asian Crisis 1997

Sep 1997 - Oct 1998 (13 months)

14.8% zero significant widening 103 162 168 172

Interest rate shock 1994

Apr 1993 - Dec 1994 (20 months)

4.2% approx +350 bps zero -317 -300 -263 -278

Credit Crunch 2008

May 2007 -Nov 2008 -53.5% zero extreme

widening -562 -776 -706 -702

Dotcom Crash 2001

Jan 2000 - Oct 2002 (33 months)

-45.4% zero significant widening -124 -305 -302 -297

Yield Curve Steepening +

Spread Widening

Prospective Scenario -3.0% +100 to +250

bpsmoderate widening -224 -236 -203 -217

Aspen: a case study of SAARecommendations



Recommendations

Portfolio reallocation

Increase in total return ($m)

Increase in income ($m)

Increase in risk capital

($m)

ROE of additional

investment

5% from cash into equity 27 13 108 12%

5% from A-rated corps into equity 25 6 31 20%

10% from US treasuries and A-rated into agency RMBS and equity 30 14 30 46%

l Increased income due to two factors:l Increased risk appetite (taking on more risk)l More efficient asset allocation

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In May investment committee recommended a 5% investment in equity

Implementation


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Tactical consideration: easier to switch from cash than A-rated corporates

Since then, market movements mean EMD yields have risen materiallyl Used SAA analysis to identify EMD was attractive from a risk perspective.

Re-ran analysis with updated EMD yields

Changes implementedl 2.5% switch from cash to equity l 2.5% from A-rated corporate to EMD


SAA possible because capital model is widely used and understood

Key takeaways


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Using the internal model liabilities can generate very different SAA results to using a liability proxy for a P&C insurer

Qualitative analysis was critical in providing:l validation of internal model analysisl an intuitive explanation to communicate results to the board


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Strategic asset allocation: case study by Aspen Re – using ...€¦ · Strategic asset allocation: case study by Aspen Re – using the internal model to change asset strategy Dr