Session 3a Asset Liability Management Strategies Zachary Brown, CFA, FRM, PRM
Asset Liability Management Strategies Session ZACHARY Z. BROWN, CFA, FRM, PRM Portfolio Manager, Milliman September 1 st, 2016 Measuring Investment Success Asset Management Metrics: Rate of return, Sharpe Ratio, Alpha Benchmarks: Market indices, Peer Group analysis These measures only consider the assets; they don t take into account the liabilities 2
Sequence of Returns Effect The optimal portfolio for a buy and hold investor will focus on performance over a long period of time The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio. 3 Sequence of Returns Effect Buy and hold investors can afford to take short term losses as long as the market eventually recovers The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio. 4
Sequence of Returns Effect Investors with large liabilities can t afford to ride out the storm The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio. 5 Measuring Investment Success Equitable US life insurance company in the 1980s Guaranteed Interest Contracts (GICs) Guaranteed 16% rates for up to 10 years Equitable invested in short term bonds Interest rates fell, Equitable was demutualized and sold 6
Measuring Investment Success McKinsey & Company, 2015 While liability risk management and investment skills both help drive earnings, risk management is the main driver of performance differentiation for value creation in life insurance in China. Further, based on similar research across life insurance markets globally, we believe that this balance will shift even more towards liability risk management excellence as the Chinese economy matures. 7 Asset Liability Management (ALM) Take into account both assets and liabilities when making decisions Who uses ALM? Financial theory offers no good reason for making a distinction between ALM as practiced by banks, insurance companies, or pensions CFA Institute, 2013 History of ALM Strategies 8
Dedication 1970s Exact matching of a stream of future cash flows Rigid, inflexible, and more expensive to implement as interest rates declined from 1982 onward 9 Immunization 1980s Match the interest rate sensitivity of the liability in present value terms Duration: Measure of how value changes as interest rates change 10
Problems with Duration Only works for small changes in interest rates Convexity: Measure of how Duration changes as interest rates change Only works for parallel shifts in interest rates Key Rate Duration: Duration for specific segments of the interest rate curve 11 Problems with Duration - Optionality In order to keep the competitiveness in the marketplace, almost all insurance companies offer embedded options in their products Society of Actuaries, 2003 Floor guarantees, prepayment risk Prepayment risk can undermine the best asset/liability management strategy if it is grounded entirely on duration Center for Insurance Policy and Research, 2012 12
Surplus Optimization 1990s Financial Accounting Standards allowed pensions to use return on assets to offset pension liabilities Incentive to invest heavily in equities The equity bear market that hit in 2000-2002 became a pension tsunami CFA Institute, 2013 13 Surplus Optimization 14
Current Best Practices Hedging Decompose liabilities into risk factors Greeks: Delta, Gamma, Rho, Vega Complex liability modelling Every policy sold to investors vs. model points Dynamic policyholder behavior Market Scenarios: Equity markets, interest rates, volatility surfaces 15 Current Best Practices Baseline: Deterministic Scenario The average profit over all scenarios is NOT equal to the profit in the average scenario SOURCE: The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty by Sam L. Savage, with illustrations by Jeff Danziger. 16
Current Best Practices Stress testing, sensitivity analysis Stochastic Scenario Analysis Scenario generator: create a large number of scenarios Computing power: computationally intensive calculations 17 Using ALM Tools Holistically ALM Tools and strategies can be used in all stages Product Design Create products that are easier to hedge Reinvestment risk: Floating rate products Equity market risk: Managed Risk Funds Nearly all of the top variable annuity living benefit writers require Vol Funds to be selected as investment options Insured Retirement Institute, 2015 18
Derivatives Tools to implement ALM Strategies: Swaps, options, futures, forwards The notional value of derivatives held by the insurance industry increased 8.6% from the previous year to about $2.02 trillion. NAIC, 2016 Flexible, low transaction costs, generally good liquidity Basis risk, Counterparty risk 19 Performance Attribution 20
Derivatives Market in China First stock index futures market - 2010 Five-year government bond futures - 2013 Industry groups likely to seek approval to launch a CDS market soon Yet the new rules have also made life more difficult for hedgers. Financial Times, 2015 21 Derivatives Market in China 22
The Future of Risk Management Demographics: as populations age, risk management becomes more important The analysis reveals that the primary difference between China s higher- and lower-performing life insurers is skill in managing liability risk. McKinsey & Company, 2015 23