In-Term Exam I. Life Insurance. Liabilities Policy reserves (the exp. payment commitment on existing policy contracts)

Transcription

1 Reinsurance & Integrated Risk Management Week 5 In-Term Exam I Thursday Lecture, Week 7. Relevant content Week 1-4. All lectures & readings are examinable. 2 Life Insurance The Balance Sheet Assets e.g. bonds, equities, govt. securities, property Liabilities Policy reserves (the exp. payment commitment on existing policy contracts) 3 1

2 Financial institutions must coordinate their management of assets and liabilities. Without ALM risk of failure! Examples: Nissan Mutual Life, General American Life. ALM is relevant to, and critical for, the sound management of the finances of any institution that invests to meet liabilities. Society of Actuaries 5 Nissan Mutual 1.2m policy holders, $17Bn in Assets Sold individual annuities, guaranteeing 5-5.5%. Drop in Government Bond Yields!!! Large gap between its commitments (annuities) and returns. 1997, went bankrupt, losses of $2.5Bn. 2

3 Yield (%) General American Life $14Bn in Assets 30 July 1999 Moody s downgrade (A2 to A3) Triggered a run! $6.8bn in debt instruments (short-term funding arrangements) it had $2.5bn in liquid assets. 7 day encashment w/in hours of downgrade -$500m w/in days - $4bn Sold to MetLife Problem: mismatch between assets and liabilities. Interest Rate Risk Historical Background U.S. Long-Term Government Bond Yields (in percent) Interest Rate Risk 1980s, demand for interest rate sensitive products Annuities and Guaranteed Income Contracts (GICs) Produced increased level of risk for life insurers. Cash Flow testing (CFT) required by some regulators. Simple scenario testing. Cash Flow matching Uncertainty of cash flows Matching reduces flexibility Immunisation ( duration matching ) 3

4 Multiple Risks Dynamic Financial Analysis (DFA) Increased popularity among non-life insurance. DFA Models usually incorporate five components. Initial Conditions Scenario Generator Financial Calculator Optimiser Results Consider a typical company (HypoCo). HypoCo s investment policy reflects three principal goals: To promote growth in equity To meet regulatory standards; and To maximise risk-adjusted long run value. HypoCo must adjust its underwriting and reinsurance policies, management must decide on an asset allocation strategy. (Example produced by Swiss Re) DFA can also help inform decisions on reinsurance strategy. Companies can reduce overall risk exposure and raise expected returns by: Purchasing more reinsurance to reduce liability risk while Increasing allocations to higher risk/higher return asset classes. 4

5 In most insurers independent committees make related decisions. Investment Pricing Insurance Policies Reinsurance Purchasing Risk ALM leads to better more coordinated decisions. What is Interest Rate Risk? Risk that the value of assets and liabilities will change due to changes in interest rates. Risk that the return on investment will be lower than expected. Risk that the cost of capital will be higher than expected. The Maturity Model The maturity model uses Malkiel s principles First principle: value is inversely related to interest rate: [10% coupon, 1-year] Second principle: change in bond price is larger for longer maturity bonds [10% coupon, 2-year] Therefore, an increase in interest rates will reduce the value of an asset (bad news) and liability (good news). 5

6 The Maturity Model The maturity model takes a portfolio approach on the basis that the same principles apply to portfolios. We can calculate the weighted average maturity of a company s interest rate sensitive assets (M A ) and liabilities (M L ). The net effect of a change in the interest rates depends on the extent and direction of the maturity mismatch of its assets and liabilities. Managing Interest Rate Risk Using the Maturity Model Based on the maturity model, if the maturity gap is 0, there will be no change in the net worth as interest rate changes. Major drawback: maturity model does not take interim cash flows into account. Therefore, maturity matching will not always result in immunizing against interest rate risk. The Duration Model What is duration? Duration is the direct measure of interest rate sensitivity of an asset or liability. It is a more complete measure than simple maturity since it takes the interim cash-flows into account. Compare interest rate sensitivity of three year bonds. 6

7 Interest rate exposure for corporations The company needs to consider the following for each borrowing or investment: Is the interest rate fixed or floating? What is the interest rate basis for floating rates? What is the currency? What is the period to maturity? Managing the exposure Once the exposure has been identified, the company needs to consider the risk management strategy. How much of the exposure to hedge Selective hedging based on its view of future interest rates (speculation?) It also needs to consider the range of instruments available to manage interest rate risk. Risk Management Tools Characteristics of Hedging Instruments Certainty Short-Term (less than 18 months) FRAs Financial futures Long-Term (greater than 18 months) Swaps Insurance Interest rate options Special clauses Caps, floors and collars Swaptions 7

8 Learning Outcomes (W5) Discuss the historical context for more active, more integrated risk management ALM. Understand the general components in DFA. Explain how interest rate risk emerges in FI and some techniques to reduce exposure. 22 8