asset liability management at munich reinsurance company

Asset Liability Management atMunich Reinsurance Company

Helsinki, 17th November 2004

Bernhard Kaufmann and Jochen Mayer

2

Asset-liability management for insurance companies

� ALM: Governance and Management

� The Munich Re ALM-Model: ALM on Macro Level

� The general Concept

� The different modules

� Reports and Analysis

� ALM and pricing: ALM on Micro Level

Agenda

3


Strategic objectives for ALM

Business focusOperational profitability Risk limitation Financial strength

– Reinsurance

• Focus on achievinga leading marketposition in targetmarkets dependingon the cycle

• Exit business notachieving targetreturns

– Primary insurance

• Strong platform forprofitable growth

• Sustainablestrengthening ofbusiness model

– Strict underwritingdiscipline

– Rigorous applicationof Value BasedManagement

– Commitment tofinancial targets

- Comprehensive riskmanagement

– Integrated view oninsurance risk andfinancial mismatchrisk

– De-risk balancesheet

– Retain clients’ andinvestors’ confidence

– Reduce dependencyon equity marketdevelopments,thereby increasingflexibility

Deliver a return to shareholders in excess of cost of capital

4


Evolution of ALM in global insurance market

4

• Development of coherent Integrated Risk ManagementFramework

• ALM processes integrated with active capital managementand other financial risk management processes

• Governance processes provides independent oversight ofaggregate financial risk position

1• Identification, measurement and monitoring of asset

and liability risks undertaken in isolation, with varyingdegrees of sophistication

• Limited or informal / ad hoc integration of individualrisk profiles

3

• ALM function and processes developed to integrate riskprofiles of both assets and liabilities

• Management action focused on the integrated asset andliability view

• Governance process provides independent oversight ofALM

2

• Enhanced awareness of the value of formalized ALMprocess

• Development of partially integrated asset and liabilitymeasurement processes

• ALM governance primarily focused on asset-side

66% ofinsurers are

less than 50%of the way

through theevolutionary

journey

90% ofinsurers

believe thatbenefits

outweigh thecosts of the

journey

Source: Ernst & Young LLP. 2004

5


ALM in the Solvency II project

Special Call for advise from CEIOPS (MARKT/2506/04-EN – App.2):

… “In the future all insurance undertakings need to have an asset-liability

management system (ALM) as part of their general business and risk

management processes. General principles concerning A/L analysis shall be

harmonized at the EU level.”…

... “One major use for ALM in pillar I is to contribute to investment planning.” …

… “standard formula for calculating the solvency capital requirement should

capture the ALM risk in a sufficiently prudent approach.” …

… “The pillar II supervisory review process should encompass the undertaking’s

ALM.” …

6


Stochasticrepresentation ofcash flowsassociated withinsurance andreinsuranceobligations on aclass of business

Portfolio ofassets that mostclosely matchesthe riskcharacteristicsassociated withthe stochasticrepresentation ofthe liabilities

Asset allocationtargets thatprovide optimallevel of returngiven thepredeterminedappetite of Boardand otherinvestmentconstraints, asdictated byexternalstakeholders (e.g.regulators, ratingagencies)

Asset allocationtargets that areselected by theAsset Managerto optimizereturn withingiveninvestment andrisk constraints

The risks andcash flowsassociated withassets of theGroup

LIABILITIES REPLICATINGPORTFOLIO

STRATEGICASSET

ALLOCATION

TACTICALASSET

ALLOCATION

ASSETS

ALMGOVERNANCE

ALM Governance of Munich Re Group

7




� The general concept




Agenda

8


What would happen if? The ALM model is anevaluation tool

An optimisation toolgenerates, for example, astrategic asset allocation

The ALM model simulates theimplications of the consideredSAA over a 5 year horizon incombination with the liabilities

The AL-team analyses thesimulated results for the

considered SAA and tradesoff risks and chances

Capital market model

Reports

Asset moduleLiability model

Life Non life

Corporate model

“The optimiser”

“The ALM model”

“The AL-team”

9


Volatility sources

Capital marketscenarios

Operativebusiness

The ALM model allows to analyse the impact ofstrategic decisions and changes in the general framework

General framework

Accounting rules

Regulation

Strategic decision

Investment strategy

Operative strategy

Distributions ofcorporate results

Balance sheet

P&L statement

Risk positions

ALM-Model

10








Agenda

11


The different Modules

Sub models

Corporate model

Capital market model

Asset model Liability model

Reports

IFRSHGB

12


The capital market model: 3000 Scenarios form the basis ofthe ALM simulation

EURO Zinsraten über einen 5-Jahres-Horizont

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1 Y 3 Y 5 Y 7 Y 10 YMaturity

Inte

rest

rat

e

1% quantile 5% quantile 10% quantile 25% quantile 50% quantile 75% quantile

90% quantile 95% quantile 99% quantile start mean

� Short term interest rates are more volatile than long termrates

� For most of the scenarios interest rates are below theaverage

� In many of the scenarios the spread between long andshort term rates reduces over time

13


The capital market model: Equity indices

EUROSTOXX

-

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

10.000

1 Year 3 Years 5 Years

Horizon

Val

ue

� The mean of the chosen calibration is clearly positive: 5-year return EUROSTOXX: 6,7% p.a.

� The probability of a loss for the EUROSTOXX isnevertheless very high at 28%.

14


MODELLING EURO ASSETS - IAS

Governments

Participations

Allianz

Ergo

Commerzbank

Corporates

Pfandbriefe

(ABS/MBS)

Equities

Loans

HVB

Cash

Real Estate

Insurance index anddividend yield

Relevant price index anddivident yield (Eurostoxx)

(Dynamic Spreads)

Static Spreads

Interest yield curve (term)

Banking index anddividend yield

Relevant real estate index

Short term interest rate

Price index and dividendyield (DAX)

Asset Classes Market value modelling

Real Estate

Affiliated Companies -consolidated

Associated Companies

Bonds – Available for sale

Bonds – Held to maturity

Bonds – Trading

Book value modelling IAS

Loans

Equity – Available for sale

Equity - Trading

Affiliated Companies –non consolidated

Cash

MarketValue

MarketValue

MarketValue

MarketValue

+

The asset model: Focus of the analysis should rule thegranularity of the model

15


� Flexible premium and budget development (GDP, CPI)

� Consideration of internal/external retrocession and FRe-treaties

� Derivation of commission and admin expenses as ratios of earned premiums

The non life model simulates catastrophe, basicand large losses based on MR risk model

Claims

Non-Life Module

Interaction withother modules

Input

Ext. Retro Finite Re

Output

Division Report

LoB Report

Currency Report

Input Input

� Cash Flows

� Balance sheet

�Income statement

INCURRED LOSSES AND PROVISIONS FOR OUTSTANDING CLAIMS ARE PROCESSED BY MEANS OF

STOCHASTIC PAY OUT PATTERN

Major Non-Life Loss and Combined Ratios (Mean and Quartiles)

0%

30%

60%

90%

120%

150%

180%

210%

20

03

20

04

20

05

20

06

20

07

20

03

20

04

20

05

20

06

20

07

20

03

20

04

20

05

20

06

20

07

20

03

20

04

20

05

20

06

20

07

Casualty OtherMarineProperty

16


Life model: reserving is strongly affected by interest rates

Average "Umlaufrendite" over 10 years (yield in %)2)

3

3.5

4

4.5

5

5.5

6

2003 2004 2005 2006 2007 2008

Change in Interest Sensitive Reserves3)

0

0.005

0.01

0.015

0.02

0.025

0.03

2003 2004 2005 2006 2007

99%-Quantil

95%-Quantil

17








Agenda

18


A number of ALM reports can be generated

� Risk analysis

� Technical results

� Capital market model scenarios

� Return and growth

� International & local GAAPfinancial statements

� Investments and

investment result

19


Balance sheet IAS

€m mean over scenarios

ASSETS Actuals 2003 2004 2005 2006 2007

Intangible assets 131 130 130 130 130

InvestmentsI. Real Estate 1.050 1.040 990 978 1.068

II. Investments in affiliated and associated enterprises 6.808 6.823 6.825 6.826 6.828

III. Loans (mortgage loans, loans to aff/ass) 666 580 582 604 627

IV. Other Securities

- Available for sale (excluding Allianz) 14.459 14.557 14.939 15.764 17.014- Available for sale (Allianz only) 2.347 2.483 2.656 2.884 3.060- Trading 56 56 56 56 56Total 16.862 17.096 17.651 18.704 20.130

V. Other investments 11.893 12.527 12.620 12.956 13.054

Total 37.279 38.067 38.667 40.068 41.706

Ceded share of underwriting provisions 1.789 1.527 1.503 1.520 1.529

Other assets 4.499 4.584 4.711 4.729 4.724

Balancing item Assets 0 410 410 410 410

20


The ALM model simulates balance sheet and incomestatement numbers for MR AG under HGB and IFRS

� Development of insurance business,premiums and claims

1. Stochastically simulated figures− Incurred losses (gross and netexpenses for claims and benefits)− Gross and net underwriting provisions

2. (Deterministically) projected figures− Gross and net earned premiums− Gross written premiums

3. Derived figures (by ratios)− Commission and admin expense ratios− Loss ratios (LR)− Expense ratios (ER)− Combined ratios (CR):= LR + ER− Ins. business result ratio:= 1 _ LR _ ER

� Security and risk measures− Relevant rating figure (S&P CAR)− Relevant solvability figures (solo

solvency)− Value at risk− Currency over/under coverage− Duration missmatch

� Assets and investment return− Asset structure at book and market

values− Unrealised capital gains and losses− Net investment return (components)− RoI (referring to the average market

value of total investments)− Performance of selected asset classes− Duration

� Rentability− Return on equity (RoE)− Comprehensive income per equity

21


Example 1: Risk/return analysis for differentstrategic asset allocations (SAAs)

Unchanged SAA

Increase in equities(SAA with higher risk)

Decrease in equities(SAA with lower risk)

Mea

n

Standard Deviation

2004 2005

2006 2007

Comprehensive Income in € bn

22


Static investment strategy

Dynamic investmentstrategy linked to VaR-limit

Example 2: Impact of dynamic investmentstrategies

23


Example 3: Analysis of duration mismatch

Definition EUR-Duration: =

Change in market value of assets andliabilities if all interest rates change by100 basispoints

EUR-Duration:=

MacAulay-duration* market value * 0.01

24


Example 4: Analysis of currency mismatch atbook and market value

Def: Currency mismatch = Market value of assets - Market value of liabilities

25


The graph shows the change of the IAS profit as a result of the first-timeimplementation of IAS 32/39 (rev. 2003) compared to the previous version.

IAS Profit (in Billion EUR)

with 90%-Confidence bands

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

new

200

3

old

2003

new

200

4

old

200

4

new

200

5

old

2005

new

200

6

old

200

6

new

200

7

old

200

7

Example 5: Effect of changes in accountingstandards (e.g. after tax profit under IAS 39 old and new)

26








Agenda

27


Primary Life Insurance – the past must be placed inperspective, lessons have been learned for the future

-8%

-4%

0%

4%

8%

12%

1994 1996 1998 2000 2002 2004

Max Discount / "Min. G'teed Rate"

Market Value Raturn

Average Participation Rate

% PA

(1)

(2)

(3)

Start ofDeregulatedMarket

Market Value EarningsExceed Declared Rates(Surpluses Accumulated)

Market Value EarningsLess than Declared Rates(Draw Down of Surplus)

The Future

(1) Estimated for 1994 & 1995, Actual for later years(2) Before allowance for Terminal Bonus, typically in the range of 0.3% to 0.5%(3) Rate applying to business written in that year

Interlinking the Fundamentals

ALM

Pri

cin

g

Hedging

Dyn

amic

Bo

nu

s

German Life

28


Securing Risk Adequate Prices in German Primary LifeBusiness – Market Consistent Pricing of Guarantees

�What is meant by ‘market-consistent’ pricing of a guarantee?

� The cost of a portfolio of assets with the same pay-offs as guarantee

in all possible scenarios i.e. the cost of hedging risk

�Why is it useful?

� Pricing: Shareholder cost of writing guarantee

� Capital: Minimum capital required to hedge risks. Can indicate drivers

of risk-based capital requirements

�For simple guarantees, formula may be available:e.g. ‘plain-vanilla’ put

options => Black Scholes formula

�Insurance guarantees usually more complex : cost dependent on Bonus

and asset management rules

�Simple formula not available �� Use simulation model

29


� Bonus Smoothing Policies (Annual &Terminal Bonus)

� Making use of direct bonusdeclaration („Direktgutschrift“)

� Consideration of cost of guaranteesand embedded options in settingbonus rates

� Special treatment for policies closeto maturity – proactively managingpolicyholders‘ reasonableexpectations

� Shareholder participation pre andpost 1994 Rules

Improving Capital Productivity Requires OptimisingManagement Actions on Both Sides of the Balance Sheet

Managing the Liabilities Managing the Assets

� Defining the Strategic AssetAllocation and PortfolioRebalancing Rules

� Developing a sound dynamichedging strategy

� Optimising reinvestment anddisinvestment decisions

� Management of unrealised gainsand losses

� Flexing the equity backing ratio inresponse to changing excesscapital levels

30


Active ALM can improve the risk/return profilesubstantially

VisionBusiness

Focus

Pri

cin

g

Dis

cip

line

Distribution & Cost Management

Risk

Man

agem

ent

Strategy

0

0.5

1

1.5Passive Policy (Market Consistent Cost) Dynamic Policy (Market Consistent Cost)

Passive BonusPolicy – Market

ConsistentCost

Dynamic BonusPolicy – Market

ConsistentCost

1.0 .1

in %AUM

Power of ManagementActions to Reduce Costs of

Guarantee & ImproveReturns for Shareholders

- ILLUSTRATION FORENDOWMENT ASSURANCE -

0%

50%

100%

150%Passive Policy (Market Consistent Cost) Dynamic Policy (Market Consistent Cost)

Assets Invested inBonds (Base

Case)

Assets Coveredby Structured

Hedge100 25

in%

- ILLUSTRATION FORENDOWMENT ASSURANCE -

Optimising InvestmentStrategy for Shareholder

Funds Provides LeveragedPotential to Improve Capital

Productivity

MARKET CONSISTENT PRICING ASSET/ LIABILITY MANAGEMENT

German Primary Life Business –Improving Capital Productivity

Required Shareholder Risk Capital

Thank you for your interest.

Münchener RückMunich Re Group

asset liability management at munich reinsurance company

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