Asset Liability Management An Integrated Approach to Managing Liquidity, Capital, and Earnings

Transcription

1 Actuaries Club of Philadelphia Asset Liability Management An Integrated Approach to Managing Liquidity, Capital, and Earnings Alan Newsome, FSA, MAAA February 28, 2018

2 Today s Agenda What is Asset Liability Management (ALM)? Case Study Overview Traditional Methods Liquidity & Interest Rate Risk Cash Flow Matching Duration Management 2 Motivation for Integrated ALM Liquidity, Capital, and Earnings Enhanced Cash Flow Analysis

3 What is Asset Liability Management? Asset Liability Management (ALM) can be defined as the practice of monitoring and controlling the mismatch between incoming (asset) and outgoing (liability) cash flows. Also referred to as Liability-Driven Investing (LDI) in the Pension industry Key ALM goals are to Ensure the ability to meet all current and future liabilities Produce sufficient excess cash flow Main considerations in ALM include Projection of assets and liabilities Selection of baseline and stress scenarios Setting criteria for successful ALM Risk monitoring, management, and mitigation 3

4 Case Study: Overview Case Study will be used to highlight key ALM considerations Liability Begin with Traditional ALM Progress to an integrated approach with Liquidity, Capital, and Earnings management Sum of Cash Flows (Base) = 100 Sum of Cash Flows (IR +1%) = 90 Sum of Cash Flows (IR 1%) = 110 Effective Duration = years Asset Universe 1, 5, 10, 30yr Fixed Rate Bonds 15yr Residential Mortgaged-Backed Security (RMBS) Effective Duration =.95 years Case Study CS Effective Duration = 4.33 years Effective Duration = 7.74 years 4 Effective Duration = years Effective Duration = years Effective Duration: (PVCF Down PVCF Up ) / (PVCF Base x 1% x 2) Base Discount Rate = 5% IR = Interest Rates PVCF = Present Value of Cash Flows

5 Background: Residential MBS Cash Flows Background 5

6 Traditional Methods: Liquidity & Interest Rate Risk Historically, ALM has focused on liquidity and interest rate risk management. Liquidity refers to the ability to meet immediate and short-term obligations with cash. Liquidity risk is generally managed with short term asset vs liability ratios, holding cash reserves, and maintaining backup liquidity sources. Interest rate risk refers to the change in value due to a change in interest rates. It is generally managed with Duration and Convexity Measures. Key goals include Ensure enough assets available to cover short-term liquidity needs Maintain an asset vs. liability cash flow pattern without large mismatches Traditional ALM strategies generally fall into Cash Flow Matching Duration Management 6

7 Traditional Methods: Cash Flow Matching Cash Flow Matching is the process of organizing a stream of asset cash flows into a pattern of relatively equal timing and amount to a corresponding stream of liability cash flows. Key Considerations Must determine an acceptable mismatch target May be difficult to acquire assets to hit target Need to periodically rebalance assets to stay close to target Cash Flow Mismatch Mitigation Strategies Replace assets / reposition portfolio Lock-in (hedge) interest rates to reduce reinvestment risk Do nothing / hope rates change favorably 7

8 Traditional Methods: Duration Management Duration Management is the process of organizing asset cash flows such that the price sensitivity to interest rates is relatively equal to that of corresponding liability cash flows. Key Considerations Accuracy and range of usefulness limited by size of shock used in calculation (e.g. +/-100bps shock) Assumes parallel change in interest rates More than one allocation can have the same result Duration Mismatch Mitigation Strategies 8 Run multiple interest rate pairs to allow for interpolation to other rate levels (e.g. run baseline and +/-50, 100, 150, and 200bps shocks) Use key rate or partial durations which capture sensitivity of price to interest rate shocks to specific nodes along interest rate curve

9 Traditional Methods: Mapping & Portfolio Optimization Process to Build Asset Portfolio: 1. Applicable liability data is mapped into m time period nodes Selected nodes (for m = 5): 1yr, 5yr, 10yr, 15yr & 30yr Cash Flow Aggregation 2. Convert the mapped liability data into a vector of weights which sum to 1 Liability Data Weights Asset Data 1yr Bond 5yr Bond 10yr Bond 15yr RMBS 30yr Bond PV Inverse Matrix 1yr Bond 5yr Bond 10yr Bond 15yr RMBS 30yr Bond (0.001) (0.001) (0.004) (0.002) (0.011) (0.014) (0.018) Case Study Portfolio Optimization CS Cash Flow 3. Map applicable asset data into time period nodes to build an m x n matrix (where n = number of assets) Optimal 1yr Bond 5yr Bond 10yr Bond 15yr RMBS 30yr Bond Initial -0.13% -0.23% -0.23% 1.50% 0.11% Min 0.00% 0.00% 0.00% 0.00% 0.00% Max N/A N/A N/A N/A N/A Calc 0.00% 0.00% 0.00% 1.50% 0.11% Final 0.00% 0.00% 0.00% 93.24% 6.76% 4. Convert the asset matrix into an m x m matrix 5. Calculate the inverse m x m asset matrix Liability Data (0.09) Weights (0.006) Asset Data 1yr Bond 5yr Bond 10yr Bond 15yr RMBS 30yr Bond (6.53) Duration Key Rate Duration 9 6. Produce the optimal asset blend by multiplying the mapped liability vector by the inverse asset matrix 7. Calculate factor to scale asset amounts to target liability level Inverse Matrix 1yr Bond 5yr Bond 10yr Bond 15yr RMBS 30yr Bond (0.262) (0.257) (0.267) (0.036) (0.366) (0.153) Optimal 1yr Bond 5yr Bond 10yr Bond 15yr RMBS 30yr Bond Initial % 5.28% % 10.01% 12.47% Min 0.00% 0.00% 0.00% 0.00% 0.00% Max N/A N/A N/A N/A N/A Calc 0.00% 5.28% 0.00% 10.01% 12.47% Final 0.00% 19.03% 0.00% 36.05% 44.92% Notional Scale % Optimizations constrained to non-negative asset weights except for notional scaling of the KRD match Discount Rate = 5%

10 Traditional Methods: Optimal Portfolios Optimization Asset Weights Cash Flow Matching: 93% (15yr RMBS) + 7% (30yr Bond) KRD Matching: 22% (5yr Bond) + 42% (15yr RMBS) + 52% (30yr Bond) + -16% (Cash) Cash Flow Key Rate Duration Case Study Traditional Optimization CS 10 All Results on a Present Value Basis Discount Rate = 5%

11 Traditional Methods: +/-1% Interest Rate Shocks Optimization Asset Weights Cash Flow Matching: 93% (15yr RMBS) + 7% (30yr Bond) KRD Matching: 22% (5yr Bond) + 42% (15yr RMBS) + 52% (30yr Bond) + -16% (Cash) Case Study Traditional Optimization CS Cash Flow Key Rate Duration 11 As expected, interest rate shocks have a larger impact on the Cash Flow Matched portfolio. However, both portfolios still have considerable cash flow mismatch in years Optimizations completely ignore Liquidity, Capital, and Earnings. Results include: Base (5% interest rate) Up (6% interest rate) Down (4% interest rate) All Results on a Present Value Basis

12 Motivation for Integrated ALM: Holistic Analysis Traditional Cash Flow (CF) Analysis is often incomplete. Depicts existing assets but ignores reinvestments Projects current liabilities but excludes new business / future liabilities Difficult to quickly analyze results across scenarios Unclear how to rank or optimize outcomes Interactions with other considerations (i.e. Liquidity, Capital, and Earnings) are not well defined Enhanced Cash Flow Analysis accounts for these deficiencies. Includes existing asset and new reinvestment purchase and payoff cash flows Includes current liabilities with steady state new business / future liabilities Separate chart which summarizes scenario results Ranking and optimization of outcomes possible with addition of Liquidity, Capital, and Earnings metrics 12

13 Motivation for Integrated ALM: Liquidity Leading cause of financial institution failures Part of ALM review, but not a huge driver of actions Historically falls within Treasury function Types of Liquidity Risk Funding refers to short-term timing differences between asset and liability cash flows. Stress Test: Run-on-the bank scenario (i.e. move liabilities forward) Market is the risk of loss in asset value due to inability to sell at a favorable price. Stress Test: Apply haircuts to asset sale values and assume longer time to sell assets Capital Market Funding occurs when liquidity sources dry up. Stress Test: Remove or reduce size of available liquidity sources 13 Fungibility is being unable to transfer assets quickly between accounts or entities. Stress Test: Remove accounts from testing and assume longer lag times in internal asset / cash transfers

14 Motivation for Integrated ALM: Capital Another key cause of financial institution failures Generally not part of traditional ALM analysis, but key factor when selecting applicable stress scenarios Historically falls within Capital function Hold capital as buffer to support solvency as of a specified probability Tradeoff between risk and return (where higher capital reduces risk but lowers return, and vice versa) Long-term / tail measure Stress Testing: Standard set of deterministic & stochastic models using various market, business, and demographic assumptions Capital / Credit metrics (i.e. WARF, spread, Reserves, etc.) should be reviewed and projected 14

15 15 Motivation for Integrated ALM: Earnings

16 Enhanced CF Analysis: Model Overview Enhanced PV Cash Flow Projection - Base Scenario 8 Earnings Capital (10) (20) (30) (40) (50) CUMULATIVE METRICS Case Study Cash Flow Matching Traditional AnalysisCS 16 - (60) YEAR Cumulative Capital Increase Base Assets Capital Drawdown Asset Purchase Earnings Liability Cumulative Earnings Cumulative Net Cash Flow Enhanced analysis provides view of Liquidity, Capital, and Earnings All Results on a Present Value Basis Discount Rate = 5%

17 Enhanced CF Analysis: Reinvestment Strategy Enhanced PV Cash Flow Projection - Base Scenario Capital Earnings Reinvestments (10) (20) (30) CUMULATIVE METRICS 1 Year of Reinvestments 5 Years of Reinvestments Case Study Cash Flow Matching CS 2 (40) 1 (50) 17 - (60) YEAR Cumulative Capital Increase Base Assets Capital Drawdown Asset Purchase Earnings Liability Cumulative Earnings Cumulative Net Cash Flow Layering on reinvestment cash flows allows for comparison of strategies Reinvest 75% of excess assets over Base Assets each year into the optimal Cash Flow Matched portfolio (based on net exposure each year) All Results on a Present Value Basis Discount Rate = 5%

18 Enhanced CF Analysis: New Business Enhanced PV Cash Flow Projection - Base Scenario Capital Earnings Reinvestments (20) (40) (60) (80) CUMULATIVE METRICS Year 1 of New Business Year 2 of New Business Case Study Cash Flow Matching CS 18 - (100) YEAR Cumulative Capital Increase Base Assets Capital Drawdown Asset Purchase Earnings Liability Cumulative Earnings Cumulative Net Cash Flow Incorporating New Business shows impact of potential growth New Business of 50%, 25%, and 25% of initial inforce over next 3 years, respectively All Results on a Present Value Basis Discount Rate = 5%

19 Enhanced CF Analysis: Scenario Analysis Cumulative PV Metric Projection with +/-1% Shocks 35 Rates +1% Case Study Cash Flow Matching CS Net Cash Flow Capital Rates -1% 5 Earnings YEAR Cumulative Capital Increase Cumulative Earnings Cumulative Net Cash Flow Net Cash Flow (Rates +1%) Net Cash Flow (Rates -1%) Liquidity, Capital, and Earnings metrics can reviewed across scenarios Includes reinvestment of 75% of excess assets over base assets New Business of 50%, 25%, and 25% of initial inforce over next 3 years, respectively All Results on a present value basis using respective scenario curve (i.e. 4%, 5%, or 6%)

20 Enhanced CF Analysis: Assumption Analysis Cumulative Results on Present Value Basis - Base Scenario Reinvest. Cash Flow Earnings Capital Impact Available Liquidity % Max Min Average Year 50 Max Average Year 50 Max Min Average Year 50 Year 1 Year 2 Year 3 0% 24.0 (35.2) (10.8) (35.2) (64) (36) (64) % 25.2 (33.0) (9.2) (33.0) (61) (34) (61) % 26.6 (30.7) (7.6) (30.7) (58) (31) (58) % 28.0 (28.2) (5.9) (28.2) (55) (29) (55) % 29.6 (25.5) (4.0) (25.4) (52) (27) (52) % 31.2 (22.4) (2.0) (22.4) (48) (24) (48) % 32.9 (19.1) 0.3 (19.0) (44) (21) (44) % 34.7 (15.4) 2.7 (15.4) (40) (18) (40) % 36.6 (11.5) 5.4 (11.4) (35) (15) (35) % 38.6 (7.3) 8.3 (6.9) (30) (11) (30) % 40.8 (3.0) 11.4 (2.1) (25) (7) (25) % (18) (3) (18) % (12) 2 (11) % (5) 7 (4) % % % % % % % Additional analysis: Other scenarios Case Study Cash Flow Matching CS Other asset mappings / assumptions Asset downgrades / defaults Policyholder behavior Borrowing & capital costs Hedging PADs Liquidity, Capital, and Earnings metrics can reviewed using various assumptions Running range of assumption combinations is an easy method to review tradeoff between relevant metrics Includes reinvestment of excess assets over base assets New Business of 50%, 25%, and 25% of initial inforce over next 3 years, respectively 20 All Results on a present value basis using 5% discount rate

21 21 APPENDIX

22 Appendix: Asset Sale Optimization Selection of initial and reinvestment asset purchase strategies are just first step in holistic analysis Should also develop methodology to evaluate if / when to sell existing holdings to reposition portfolio Criteria will vary by scenario, but decision will be influenced by Individual holding factors Current market expectations Investment universe Overall asset mixture Liability management needs Liquidity, Earnings, & Capital 22

23 Appendix: Incomplete List of ALM Activities Asset-liability optimization mapping and monitoring Effective and key rate durations are most common New Business analysis Inforce liability developments Asset holding analysis Contribution to risk by holding Scenario generation & impact analysis Daily cash flow review and projection Include ALL cash flows Hedging & macro solutions Asset Modeling Periodic assumption & methodology review 23