The Evolution of ALM in Asia. Some Food For Thought. Mark Saunders, FIA, FASI, FSA

The Evolution of ALM in Asia Some Food For Thought Mark Saunders, FIA, FASI, FSA Principal & Managing Director, Asia Tillinghast Financial Services Business Leader, Asia-Pacific June and July 2005 Joint Regional Seminar in Asia on Asset Liability Management Beijing, Hong Kong, Taipei and Singapore Note that this presentation is incomplete without the accompanying supplementary oral briefing 2004 Towers Perrin

Agenda 1. Introduction 2. Evolution 3. Do you really understand your business? 4. Best Practice Financial Management Framework 5. Understanding Profitability and Value -- revisited 6. Some Key Points 7. Best Practice ALM 8. Concluding Remarks 2004 Towers Perrin 2

1a. Today s Speaker Introduction Mark Saunders FIA, FASI, FSA Mark Saunders is a Principal of Towers Perrin and Managing Director of Tillinghast s financial services business operations in Asia-Pacific. He is a member of Tillinghast s Leadership Council. Mark has hands-on in depth experience of working in Asia since 1989 (firstly in Korea and been permanent resident in Hong Kong since 1994). Since joining Tillinghast he has led numerous high profile assignments for insurers throughout Asia. Mark is a leading practitioner of appraisal value determination of Asian insurers having valued more than 100 companies. Prior to joining Tillinghast, Mark started his career in the insurance industry in the UK in the 1980 s and was the Chief Executive of the Asia-Pacific operation of UK life insurer, Clerical Medical Investment Group (CMI) and an Executive Director of the Boards of CMI Financial Management Services and Coryo-CM (CMI s joint venture in Korea). Mark undertakes Appointed Actuary duties for Hong Kong and Singapore life insurers (he has been Appointed Actuary of six companies) requiring in-depth knowledge of the operations and financial management experience and skills. He has also undertaken High Court-required Independent Actuary duties for business transfers and Expert Witness assignments for insurers successfully providing Expert Witness testimony in the Court of First Instance in Hong Kong. 2004 Towers Perrin 3

1b. Speaker -- Introduction (continued) Mark provided the actuarial Expert Opinion in the Prospectuses in December 2003 for the groundbreaking IPO of China Life s dual listing in New York and in Hong Kong. He was also the Expert Actuary of the Actuarial Consulting Report in Great Eastern s Circular to Shareholders in relation to OCBC s voluntary unconditional offer for all Great Eastern shares in May 2004. Mark has undertaken memberships of various insurance-related, regulatory and professional Committees such as: Member of the Insurance Advisory Committee of the Hong Kong SAR, a Statutory body overseeing the insurance industry and established under the Insurance Companies Ordinance Member of the Hong Kong SAR Securities and Futures Commission Committee on Investment- Linked Assurance and Pooled Retirement Funds Member of the China Insurance Regulatory Commission ( CIRC ) Task Force for Economic Value Reporting He is a regular speaker and chairperson at conferences and seminars as well as author of numerous articles and papers relating to the Asian insurance industry. Mark is a Fellow of the Institute of Actuaries (UK), a Fellow of the Actuarial Society of India and a Fellow of the Society of Actuaries (US), and a Fellow member of both the Actuarial Society of Hong Kong and the Singapore Actuarial Society. He has both a BSc (Honours) degree and Post Graduate Certificate of Education in Mathematics from Manchester University, UK. 2004 Towers Perrin 4

1c. I am going to cover today. ALM Theory and Practice Evolution in Asia Best Practice Investments Profitability and Value Investments Profitability & Value ALM 2004 Towers Perrin 5

2. Fundamental problem and driver of ALM in Asia Negative Interest Spreads What? When? Where? Why? How? Do you know how BIG this problem is? Japan Korea Taiwan China. 2004 Towers Perrin 7

3. Do you really understand your business? Some Food For Thought How good are your Financial Management (Reporting) Systems (Processes)? Do you (and your stakeholders): Know how much your business is worth? Know what makes you money and what loses you money? Truly understand your sources of profit (loss)? Know how well you are managing your in-force business? Know how profitable your new business is? Know how efficiently you are managing your capital? Understand your largest risk exposures (and so how they are changing)? Evaluate options for managing your business and risk responsibly? Know whether you are optimising returns for your risk appetite/profile? Know how close you are to best practices? Know whether your value assessment/reporting methods: provide reasonable comparisons between different lines of business? help you properly price your new products? adequately allow for costs of options and guarantees? adequately allow for risk and cost of capital? 2004 Towers Perrin 9

4. ntegrated Risk and Capital Management Tillinghast Financial Management Framework integrates risk, capital and value management Risk management decisions can be formed only after appropriate evaluation and measurement of required capital and returns Risk Characteristics Drives Risk Profile of Business Segment Business Event Operational Drives Organisation Strategies Drives Capital Required to Support Risk Regulatory Rating agency Economic Economic Value Creation Returns on capital value in excess of hurdle rate of return 2004 Towers Perrin 11

5a. Introducing: Market-Consistent Embedded Values ( MCEV ) Leading-edge techniques Combines concepts from two branches of Modern Finance Theory Financial Economics Corporate Finance Enhancing traditional embedded value techniques 2004 Towers Perrin 13

5b. What are these Modern Finance Theory Concepts? Diversification Risks that can be diversified away do not command any risk premium Replication Systematic risks can be replicated through (dynamic) investment in a portfolio of traded assets No-arbitrage If two portfolios have exactly the same payouts in all possible circumstances, then they have the same value Capital Structure Theory The value of a company is more (or less) than the sum of its discrete parts 2004 Towers Perrin 14

5c. Enhancing Traditional Embedded Value Techniques MCEV Techniques Traditional embedded value techniques Embedded values determined using a deterministic discounted cashflow methodology And make implicit allowance for the cost of investment guarantees and policyholder options, asset/ liability mismatch risk, credit risk and the economic cost of capital through the use of a risk-adjusted discount rate MCEV techniques Make explicit allowance for the above factors Address the following important questions in a robust manner 1) What risk discount rate should we use? 2) How to allow for embedded options and guarantees? 3) How to reliably calculate the cost of capital? 2004 Towers Perrin 15

5d. Simple Illustrative Example Hot Product??? What What is is the the Value/Profitability? Initial Investment $10,000 Guaranteed Return Guaranteed Maturity Benefit Risk Free Rate Equity Return (best estimate) Value/Profit = 4% per annum $12,167 after 5 years 5% per annum 7% per annum????? 2004 Towers Perrin 16

5e. Simple Illustrative Example 1 What What is is the the Value/Profitability? Sell a Bond (LIABILITY) 5% 100 105 Buy Lower Rated (ASSET) 6% 100 106 Net Impact 0 1 2004 Towers Perrin 17?

5f. Simple Illustrative Example 2 What What is is the the Value/Profitability? Sell a Bond (LIABILITY) Buy Equity (ASSET) Net Impact 5% 100 105 7% 100 107 0 2??? No arbitrage is a key principle of financial economics 2004 Towers Perrin 18

5g. Simple Illustrative Example Hot Product??? What What is is the the Value/Profitabilty? Initial Investment $10,000 Guaranteed Return Guaranteed Maturity Benefit Risk Free Rate Equity Return (best estimate) Value/Profit = i) $442 ii) $1,325 iii) Other iv) $467 4% per annum $12,167 after 5 years 5% per annum 7% per annum????? 2004 Towers Perrin 19

6. Some Key Points and more Food for Thought -- Are you measuring Value/Profitability correctly? -- What s more important: Assets or Liabilities? How do you assess value/profitability? You cannot simply create value / improve profitability by investing in riskier assets You need to truly understand the risk versus reward trade off No free lunches but are there free snacks in Asia? Do people really WANT guarantees? if they understood the cost and were properly charged for them? Revisit your potential liabilities via thoughtful product features and design Assets or Liabilities? 2004 Towers Perrin 21

The remainder of this presentation will follow our suggested approach for implementing the ALM framework Background and context Define the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Disciplined approach More time invested up-front pays greatest rewards Effective Communication 2004 Towers Perrin 23

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework What is ALM? A definition (US SOA task force): "Asset - Liability Management is the ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints. Coordination of decisions about assets and liabilities Dynamic process of continual revision to achieve objectives for organizational and regulatory risk levels given certain constraints ALM is an ongoing process, not a one-time exercise The purpose of ALM is not necessarily to eliminate or even to minimise risk The goal is to achieve financial objectives subject to risk tolerances and other constraints 2004 Towers Perrin 24

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models A tool to quantify the financial impact of changing economic conditions Implementing the ALM Framework Economic scenarios (e.g., inflation, asset class returns) Asset class behaviour Liability behaviour Asset/liability tactics and strategies Optimization Financial Results (ALM Metrics) 2004 Towers Perrin 25

8% 7% 3.20% 7% 6.80% 2.50% 6% 8% 6.50% 6.60% 1.90% 3.10% Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework A continual management process Assess Risks Articulate Strategies Evaluate Strategies Set the agenda Establish business performance requirements Assess organization capabilities Build the change strategy Align & deliver Refine Strategies Develop / Refine Best Strategies Implement Strategies Monitor Performance and Environment Operating Margin 9% 8% 16 14 2000 Target 7% 6% 5% 4% 3% 2% 12 10 8 6 4 1% 2 1999 0% 2% 4% 6% 8% 0% 1997 1998 1999 2000 YTD yields-new invmts portfolio yields GNP deflator 0 1997 1998 1999 2000 YTD # catastrophes # bad faith lawsuits 2004 Towers Perrin 26

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework ALM can be used for many purposes ALM for Capital Management Given the business as it currently is, calculate the capital required to achieve target levels of security How do we define security? ALM as a Decision Tool ALM and Increasing Shareholder Value Helps you identify the relative riskiness of different strategies Results from asset mix A or B Results from adjusting the asset mix as financial conditions change using a set of defined rules ALM is a risk management tool that can be used to increase shareholder value by Highlighting where risks may not be appropriately priced Helping to identify appropriate capital levels to use for pricing Helping the company test different strategies so that the risk/value trade-off can be optimised 2004 Towers Perrin 27

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework ALM in summary What ALM does What ALM does NOT do Helps you identify potential areas of risk and opportunity by understanding the financial characteristics of both sides of the balance sheet Helps you identify potential strategic asset allocations and management strategies consistent with overall company objectives and risk tolerance levels Provides a systematic method for determining asset allocation benchmarks and performance targets Forms an integral part of identifying and managing financial and operational risks in the company Eliminate financial risk Solve all your financial problems Provide the asset allocation that will yield the highest return Provide a once-and-for-all solution Make up for lack of management of other areas of risk 2004 Towers Perrin 28

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Micro versus Macro ALM Micro Level ALM Macro Level ALM Specific practical management issues or problems including line-of-businessspecific considerations Asset allocation/investment strategies, including the use of financial hedging techniques Product development and pricing, especially important for asset and liability profiles with inherent options Measuring, analyzing and controlling the options embedded in insurance products Balance sheet surplus management Capital management and allocation Corporate policy and strategic considerations Establish an ALM Committee Develop the role of the ALM Manager and ALM Unit Develop ALM Metrics Develop modeling tools, including software, to facilitate ALM analysis Measure performance and benchmarking against best practices Conduct asset and liability experience studies 2004 Towers Perrin 29

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Development of an ALM policy statement and procedures manual is critical An insurance company is made of many people and many functions. In order for successful execution of ALM, the roles and responsibility of the ALM manager, the ALM committee and the ALM department must be clearly defined. Tillinghast s surveys* of Best Practices indicate the ALM committee: Sets investment policy and asset philosophy Develops investment performance benchmarks Establishes a high-profile group (e.g. CFO, CIO and other senior executives) with major decision making power Acts as a forum for exchanging ideas and setting policy Reviews and monitors ALM work that the ALM department performs The ALM department must be appropriately resourced and understand the manifestos given by the ALM committee *Tillinghast regularly conduct a number of industry surveys, for example: Shareholder Value Management Survey, Financial Services CFO Survey. 2004 Towers Perrin 30

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Setting Investment Strategy -- Policy and Objectives SIPO Four distinct steps 1. Construct Liability Model 2. Set Investment Performance Objectives 3. Develop the Investment Strategy and Asset Liability Model 4. Analyse results and assess the Alternatives Key Considerations include: Regulatory/business requirements Policyholder requirements Shareholder requirements * Investment asset classes and their risk profiles 2004 Towers Perrin 31

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Establish a macro level ALM framework Retrospective Performance Benchmark Asset Risk Manager Asset Philosophy Guideline Asset Manager Asset Results ALM Committee ALM Manager ALM Department Financial Results Liability Risk Manager Liability Philosophy New Business/ In Force Decisions Liability Results Modelling Assumptions Experience Study 2004 Towers Perrin 32

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Align company objectives What are the Company Objectives: Market share or Growth (impact on capital requirements) Brand or target market (product design and channel economics) Short term earnings volatility Product profitability Embedded value / Appraisal value Risk based capital requirements Align financial objectives with Company objectives Where are the key opportunities and risks? Asset liability matching or asset liability management? Gain a common understanding of probabilities easier said than done. Different people have different risk utilities and different perceptions of what x% chance means! 2004 Towers Perrin 33

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Practical example: Understanding Probabilities What does x% chance MEAN??? Different perceptions Different risk utilities????? P(event) = 16.7%??? Risk worth taking??? Who wants to be a millionaire? -- What is the BEST strategy? What would YOU do??? $64,000. Correct then increase to $125,000 Incorrect then decrease to $32,000 Fifty-fifty : Answer is (a) or (d) Correct then win $61,000 plus opportunity to win more Incorrect then lose $32,000 2004 Towers Perrin 34

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Assess risk tolerances and identify constraints Assets: Interest risk Equity risk Liquidity risk Currency risk Credit risk Derivatives Liabilities: Long term guarantees on Traditional products Supportability of dividend and bonuses Minimum guarantees on investment contracts Valuation interest rates dependent on investment assets Financial reporting Business/regulatory requirements: Solvency (statutory or internally imposed) Timing/amount of liability cash flows Liquidity Currency Policyholder requirements: Guarantees Reasonable Expectations Shareholder requirements: Embedded Value Surplus IRR Investment asset class restrictions: Credit quality Concentration Equity Domestic/global 2004 Towers Perrin 35

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Identify the key performance indicators Economic Value Current Capital Future Net Income Future Required Capital Underwriting G/L Taxes Subsidiary Income Investment Income Premiums Benefits and Expenses Reinsurance Interest and Dividends Capital G/L Investment Expenses Asset Default Financial and Operational Strategies Asset Risk Liability Risk Business Risk Event Risk 2004 Towers Perrin 36

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Define the output requirement before modelling Select risk measures that are meaningful to a senior management audience, and are relevant to the stated corporate objectives, for example: Risk exposure by product line and for total company Risk of not meeting product guarantees Dollar impact on value for given change in interest rates Downside risk - worse case results Important features from cash flow analysis Impact on capital requirements Seamless process from collation of output from asset liability model to producing management report Require template to assemble regularly reported information Allowance for special issues that deserve management attention Assign responsibilities for each section of report, and for overall collation EFFECTIVE COMMUNICATION Good way to check:.. Are you getting the correct response? The meaning of communication lies in the response you get! Be responsible 2004 Towers Perrin 37

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Key Message 萬丈高樓平地起 2004 Towers Perrin 39

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Evolution -- A step by step approach Lessons from our ALM implementation assignments We find that with a relatively new and revolutionary concept, incremental implementation works best. The best training is the doing and making the effort to understand Starting with a relatively small self-contained task helps staff and management to understand the key issues, and to build their competencies. For example, start with setting a framework to develop an investment strategy for a particular product or fund. Investigate trying to match cashflows and then assess impacts of various scenarios and different asset portfolios Then extend to practices in the entire Company Pricing and product development and design Policyholder dividend strategy and other discretionary options Impact on other business decisions, e.g. reinsurance Performance management The ALM process will need to be continually monitored and updated as circumstances change: Regulatory changes Policyholder behaviour Management behaviour Competition Capital market developments 2004 Towers Perrin 40

Background and context Design the ALM Framework Identify Risks and Design KPIs Construct Models Implementing the ALM Framework Practical considerations and conclusions Learn to walk before you try to run Start with a relatively simple, understandable process, model and results Agree what you want to achieve and what can actually be achieved Improve the process incrementally Ensure you are measuring value/profitability correctly. Consider various measures. Understand the risk you are taking. Assets: Look to optimise returns at a portfolio level for a given acceptable level of risk. (Efficient Frontier). Liabilities: Design policy benefits and features and your overall liability portfolio to minimise risk for a given acceptable level of return. Consider assets and liabilities TOGETHER Finally ALM is a journey that best practice insurers undertake. Communicate effectively and take responsibility for effectiveness The ALM process provides insights to help management make decisions to run the company in an optimal manner. To stay ahead in business, the better informed you are, the better placed you are to prosper 2004 Towers Perrin 41

Mark Saunders Principal & Managing Director, Asia Tillinghast Financial Services Business Leader, Asia-Pacific Telephone: +852 2593 4535 Fax: +852 2525 9706 E-mail: mark.saunders@towersperrin.com www.towersperrin.com/tillinghast 2004 Towers Perrin 42