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Asset Liability ManagementAsset Liability ManagementAsset Liability Management Asset Liability Management in Life Insurance Industry inin Life Insurance Industry inin Life Insurance Industry in in Life Insurance Industry in IndiaIndia——Issues and concernsIssues and concerns

Dr. R KannanDr. R KannanDr. R KannanDr. R KannanMember (Actuary)Member (Actuary)

I R D AI R D A

CILA Mumbai AUG 28, 2009 1

Definition of ALM Definition of ALM The SOA defines ALM as “the practice of The SOA defines ALM as “the practice of

managing a business so that decisions on managing a business so that decisions on g gg gassets and liabilities are assets and liabilities are coordinatedcoordinated; or ; or more broadly themore broadly the ongoingongoing process ofprocess ofmore broadly …..the more broadly …..the ongoingongoing process of process of formulating implementing monitoring and formulating implementing monitoring and revisiting strategies related to assets andrevisiting strategies related to assets andrevisiting strategies related to assets and revisiting strategies related to assets and liabilities in an attempt to achieve liabilities in an attempt to achieve financial financial objectivesobjectives for a given set of risk tolerance for a given set of risk tolerance and constraints”and constraints”


Why we must consider ALM?Why we must consider ALM?Why we must consider ALM?Why we must consider ALM?Mismatching could have serious implications for the financialMismatching could have serious implications for the financial Mismatching could have serious implications for the financial Mismatching could have serious implications for the financial viability, as evidenced by collapse of many life insurersviability, as evidenced by collapse of many life insurers

Prudent management of ALM accounts for a good reward in RBCPrudent management of ALM accounts for a good reward in RBCALM answers the strategic questions vizALM answers the strategic questions viz ALM answers the strategic questions, viz.,ALM answers the strategic questions, viz.,

availability of adequate capital for solvency in stressed scenario; availability of adequate capital for solvency in stressed scenario; how to make a trade off between risk and return; how to make a trade off between risk and return;

h t i th ti l th f i i th i k tith t i th ti l th f i i th i k tit what is the optimal growth of premium, given the risk appetite; what is the optimal growth of premium, given the risk appetite; adequacy of reinsurance arrangements;adequacy of reinsurance arrangements; optimal use of risk mapping and evaluation of alternative strategy optimal use of risk mapping and evaluation of alternative strategy


Factors contributed to the evolution Factors contributed to the evolution of ALM techniquesof ALM techniques

E h d tiE h d ti Enhanced computing powerEnhanced computing power Deepening and broadening of financial markets and Deepening and broadening of financial markets and

consequent availability of varieties of financialconsequent availability of varieties of financialconsequent availability of varieties of financial consequent availability of varieties of financial instrumentsinstruments

Competitive forcesCompetitive forces——offering of high risk options, riskier offering of high risk options, riskier pp g g p ,g g p ,investment portfolios, more interestinvestment portfolios, more interest--sensitive products, sensitive products, greater guarantees on return, hence higher risk for greater guarantees on return, hence higher risk for insurersinsurersinsurersinsurers

Regulatory restrictions/ guidelines on investmentRegulatory restrictions/ guidelines on investment Taxation of financial instrumentsTaxation of financial instruments Taxation of financial instrumentsTaxation of financial instruments Market based selfMarket based self--regulation of asset related risksregulation of asset related risks


Actuarial categorization of risksActuarial categorization of risksActuarial categorization of risksActuarial categorization of risksC1C1 d i i i kd i i i k d d li i kd d li i kC1C1——Asset depreciation riskAsset depreciation risk Losses due to decline in market Losses due to decline in market

value, which has inverse value, which has inverse relationship with interest ratesrelationship with interest rates

C2C2——pricing riskpricing risk Mortality, morbidity and expenses Mortality, morbidity and expenses higher than expectedhigher than expected

C3C3——interest rate changeinterest rate change Impact of fluctuating interest Impact of fluctuating interest hi h i diff fhi h i diff frates, which is different for asset rates, which is different for asset

and liabilitiesand liabilities

C4C4 b i i kb i i k L l i k l t h dL l i k l t h dC4C4——business riskbusiness risk Legal risk, regulatory changes and Legal risk, regulatory changes and tax changes, venturing new tax changes, venturing new business etc.,business etc.,


Macro relationshipMacro relationship——some basic some basic factsfacts

A i i th i d i ld t t it dA i i th i d i ld t t it d A rise in the required yield to maturity reduces A rise in the required yield to maturity reduces the price of the fixed income securitythe price of the fixed income security——hence a hence a downward sloping curve exists between marketdownward sloping curve exists between marketdownward sloping curve exists between market downward sloping curve exists between market value and yield to maturityvalue and yield to maturityThe longer the maturity of a fixed incomeThe longer the maturity of a fixed income The longer the maturity of a fixed income The longer the maturity of a fixed income security, the greater its fall in price and market security, the greater its fall in price and market value due to an increase in the interest ratevalue due to an increase in the interest ratevalue due to an increase in the interest rate.value due to an increase in the interest rate.

The decrease in the value of the security The decrease in the value of the security increases at a diminishing rate for any givenincreases at a diminishing rate for any givenincreases at a diminishing rate for any given increases at a diminishing rate for any given increase in interest rateincrease in interest rate


Macro relationshipMacro relationship——some basic some basic facts (contd.,)facts (contd.,)

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1,500.00

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-0% 10% 20% 30% 40% 50% 60%

Yield to Maturity

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apita

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s (

0 1 2 3 4 5 6 7 8

Maturity of the Bond


Maturity methodMaturity methodMaturity methodMaturity method

I th t it th d if th t it f tI th t it th d if th t it f t In the maturity method, if the maturity of assets In the maturity method, if the maturity of assets is greater than maturity of liabilities, any change is greater than maturity of liabilities, any change in the interest rate will affect the value of assetsin the interest rate will affect the value of assetsin the interest rate will affect the value of assets in the interest rate will affect the value of assets more than liabilities. Hence maturity method, more than liabilities. Hence maturity method, considers only direction and magnitude of the considers only direction and magnitude of the maturity and does not consider cash flowsmaturity and does not consider cash flowsmaturity and does not consider cash flows. maturity and does not consider cash flows. Hence the evolution of the ALM pays attention Hence the evolution of the ALM pays attention towardstowardstowardstowards

Macaulay durationMacaulay duration Modified durationModified duration Modified durationModified duration Option adjusted durationOption adjusted duration convexityconvexity


convexityconvexity

Macaulay DurationMacaulay DurationMacaulay DurationMacaulay Duration

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Modified durationModified durationModified durationModified duration

Macaulay’s duration computes the present value Macaulay’s duration computes the present value weighted average time to maturity of the cash weighted average time to maturity of the cash flows of a certain financial instrument. flows of a certain financial instrument.

The duration method is more appropriate than a The duration method is more appropriate than a pp ppp pmaturity method to measure interest rate risk maturity method to measure interest rate risk because it not only takes into account the because it not only takes into account the yymaturity but also the timing of the cash flows of maturity but also the timing of the cash flows of the instrument or portfolio exposed to interest the instrument or portfolio exposed to interest p pp prate risk. It measures the "average life" of the rate risk. It measures the "average life" of the asset or liability.asset or liability.


Modified durationModified durationModified durationModified duration

The modified duration of financial The modified duration of financial instruments is a measure of price instruments is a measure of price ppsensitivity of a fixed set of cash flows to sensitivity of a fixed set of cash flows to small changes in the single interest ratesmall changes in the single interest ratesmall changes in the single interest rate. small changes in the single interest rate.

The higher the measure of duration, The higher the measure of duration, h i i ( l i ) i hh i i ( l i ) i hthe more sensitive (elastic) is the the more sensitive (elastic) is the

value of the financial instrument to value of the financial instrument to changes in interest rates.changes in interest rates.


Option adjusted durationOption adjusted durationOption adjusted durationOption adjusted duration The optionThe option--adjusted duration like the modifiedadjusted duration like the modified The optionThe option adjusted duration, like the modified adjusted duration, like the modified

duration, is a measure of price sensitivity. The duration, is a measure of price sensitivity. The difference is that optiondifference is that option––adjusted duration is a adjusted duration is a much more accurate measure of price sensitivitymuch more accurate measure of price sensitivitymuch more accurate measure of price sensitivity much more accurate measure of price sensitivity if the cash flows depend upon the path that if the cash flows depend upon the path that interest rates take. This is nothing but elasticity interest rates take. This is nothing but elasticity of price with respect to the interest rateof price with respect to the interest rateof price with respect to the interest rateof price with respect to the interest rate

OptionOption--adjusted Duration = adjusted Duration = --d Price/ d Price/ didiPricePricePricePrice

This expresses how much the price will change This expresses how much the price will change ((dPricedPrice) as a result of small changes in interest ) as a result of small changes in interest ates (ates (didi) and is e p essed in te ms of a atio b) and is e p essed in te ms of a atio brates (rates (didi), and is expressed in terms of a ratio by ), and is expressed in terms of a ratio by

dividing by the beginning price. dividing by the beginning price.


Option adjusted durationOption adjusted durationOption adjusted durationOption adjusted duration

The duration of a bond is always smaller than its The duration of a bond is always smaller than its maturity. The only exception is with a zeromaturity. The only exception is with a zero--coupon bond where its duration and maturity coupon bond where its duration and maturity are equal. are equal.

Increasing the coupon rate while keeping its Increasing the coupon rate while keeping its maturity and the yield constant will decrease the maturity and the yield constant will decrease the y yy yduration of the bond. Bonds with higher coupons duration of the bond. Bonds with higher coupons distribute relatively more cash flows earlier distribute relatively more cash flows earlier yydecreasing the ”average life” of the bond.decreasing the ”average life” of the bond.


D u r a t io n v . C o u p o n R a te

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Duration v. Yield

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Yield

Dur


ConvexityConvexityConvexityConvexityC it i d fi d th dC it i d fi d th d Convexity is defined as the second Convexity is defined as the second derivative of price with respect to derivative of price with respect to interest rates divided by the price, interest rates divided by the price, and is a meas e of ho theand is a meas e of ho theand is a measure of how the and is a measure of how the duration changes as interest rates duration changes as interest rates change.change.A iti it i dA iti it i d A positive convexity is a good A positive convexity is a good attribute for an asset to have, for attribute for an asset to have, for example if the interest rate example if the interest rate increases by 100 basis points theincreases by 100 basis points theincreases by 100 basis points the increases by 100 basis points the asset will gain more value than if asset will gain more value than if the interest rate falls by the same the interest rate falls by the same amount Liabilities on the otheramount Liabilities on the otheramount. Liabilities, on the other amount. Liabilities, on the other hand, benefit from negative hand, benefit from negative convexity convexity


ImmunizationImmunizationImmunizationImmunizationI i ti k t t h i t t tI i ti k t t h i t t t Immunization seeks to match interest rate Immunization seeks to match interest rate sensitivities of assets and liabilities.sensitivities of assets and liabilities. By so doing, By so doing, the company will hopefully be protected from athe company will hopefully be protected from athe company will hopefully be protected from a the company will hopefully be protected from a change in interest rates. change in interest rates. We look for an asset portfolio which hasWe look for an asset portfolio which has We look for an asset portfolio which has We look for an asset portfolio which has sufficient value to fund the liabilities, but we sufficient value to fund the liabilities, but we relax the requirement of cashrelax the requirement of cash--flow matchingflow matchingrelax the requirement of cashrelax the requirement of cash flow matching. flow matching. Instead, we require that the Instead, we require that the sensitivity to sensitivity to changes in interest rateschanges in interest rates is equal on the is equal on the gg qqasset and liability sidesasset and liability sides. That is, we . That is, we immunizeimmunize against interest rate changesagainst interest rate changes. .


g gg g

ReddingtonReddington immunization ruleimmunization ruleReddingtonReddington immunization ruleimmunization rule

NPV of assets = NPV of liabilitiesNPV of assets = NPV of liabilities Duration of assets = duration of liabilitiesDuration of assets = duration of liabilities Duration of assets duration of liabilitiesDuration of assets duration of liabilities The first two conditions imply that the The first two conditions imply that the

i bilit f li biliti h ld b lli bilit f li biliti h ld b llvariability of liabilities should be smallvariability of liabilities should be small Convexity of assets > convexityConvexity of assets > convexity ofofConvexity of assets convexity Convexity of assets convexity of of

liabilitiesliabilities


Various steps in the ALMVarious steps in the ALMVarious steps in the ALMVarious steps in the ALM

P f li i b d liP f li i b d li Portfolio segmentation by product linePortfolio segmentation by product line CashCash--flow managementflow managementgg Portfolio gap analysis, including maturity Portfolio gap analysis, including maturity

analysis and interest rate sensitivityanalysis and interest rate sensitivityanalysis and interest rate sensitivity analysis and interest rate sensitivity analysisanalysisSimulation analysis including cash flowSimulation analysis including cash flow Simulation analysis, including cash flow Simulation analysis, including cash flow testing and dynamic solvency testing testing and dynamic solvency testing

Optimization analysisOptimization analysis Hedging strategies for investingHedging strategies for investing


Hedging strategies for investingHedging strategies for investing

DurationDurationi f h 31 h 31 h 31 h 31Line of

businessMarch 31, 2007Assets

March 31, 2007 Liabilities

March 31, 2008Assets

March 31, 2008 Liabilitiesssets ssets

Non-par annuities

6.5 –8.1 7.5 –10.3 6 – 7.4 8.2 – 12.4

SP term d

4.5 –5.6 5.7 – 7.4 5.2 –6.1 5.9 –7.7product

P 6 7 8 5 8 5 10 7 5 3 7 4 8 3 10 9Par-endowment product

6.7 – 8.5 8.5 – 10.7 5.3 – 7.4 8.3 –10.9

Issues at handIssues at handSingle premium products what difference between A Single premium products—what difference between A and L on economic basis ?

Participating liability—proportionate change in assets is p g y p p gslightly more than that of liabilities?

ULIPs—no duration match required for unit reserves?Assets valued at book value liabilities at consistent Assets valued at book value –liabilities at consistent basis—is it appropriate ?

Contradiction with GN2—” if changes would result in a h h l b l h h d bchange in the aggregate liability that is not matched by a

change in market value of corresponding assets, the actuary should consider as to what provision is required y p qas contingency margin, having regard to the consequences should the provision prove insufficient”

Issues at hand ( contd )Issues at hand ( contd.,)Need for a quasi regulatory balance sheet taking assets at market Need for a quasi-regulatory balance sheet –taking assets at market value with due allowance for MAD?

What kind of stress tests be used –99th percentile with one year horizon?horizon?

Monitor the movement of free assets? Projection of capital requirement—working out of resilience capital

for the future?for the future? Sensitivity of the company’s financial strength to the following: New business volume Business mix Business mix Expense control

H t id d t ? How to avoid over prudent ?

Thank youThank you

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