International Association for the

Study of Insurance Economics

tudes et Dossiers
Extract from

tudes et Dossiers No. 340

4th International Insurance and Finance
Seminar of The Geneva Association
6-7 December 2007
London

February 2008

Working Paper Series of

The Geneva Association

Association Internationale pour l'Etude de l'Economie de l'Assurance

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The Geneva Association_________________________Etudes et Dossiers no. 340

Efficient ALM
Active Management of
Asset/Liability Risk
Anthony Bice

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

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Copyright 2007 Oliver Wyman

LON-MOWAB1MKT-146

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The Geneva Association_________________________Etudes et Dossiers no. 340

Insurers are re-examining how they create value from different activities
3 Manager Model

Liability management
Value contribution at point of sale:
Raising liabilities cheaply
Manufacturing/
product
development
(New Business)

Sales and
distribution
(New Business)

Value contribution after point of sale:

Managing liabilities to, or better than, expectations

Underwriting
(New Business)

Strategic balance sheet management

Capital optimisation
Capital allocation
Tax optimisation
Funding, contingency plans

Servicing/active
policy mgmt.
(In-force)

Administration/
claims mgmt.
(In-force)

Value contribution: Taking good A/L positions

Risk transfer, e.g.
Reinsurance
Securitisation

Asset management

Links via
Strategic
Planning,
performance
targets and
limit setting

Strategic asset allocation

Hedging

Value contribution: Beating asset class benchmarks

Asset origination

Investment management

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

In particular, they are asking what is the role of ALM in the new competitive environment

Minimize risk
Protect value by avoiding
exposure of net assets to
market risks
We are an insurer,
not a hedge fund

Maximize opportunity
Create value by seeking
exposure of net assets to
selected markets (e.g. illiquid
markets)
Insurers have an advantage
investing in certain markets

Considerations when reducing exposure

Create value by seeking

exposure of net assets to
markets opportunistically
Given our size, we should
invest actively

Considerations when increasing exposure

Life insurance

Risky investments are part of product quality from

the policyholders perspective in many markets (p/h
participation in excess returns)

Policyholders participate in the upside, but not

equally in the downside, reducing the value-creation
potential for shareholders

All investment return belongs to shareholders

General insurance

The exposure to market risk can be reduced without

any effect to the franchise

Risk Appetite statement is used to align risk-taking with strategic objectives and core
competencies
LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

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The Geneva Association_________________________Etudes et Dossiers no. 340

The new Efficient ALM requires four key competencies

Improved risk measurement

and monitoring

ECap on a desktop
capabilities to allow overall
position to be tracked
frequently and accurately

Static/dynamic hedging as a
core part of ALM risk
management

Requires understanding of
Risk Minimising Portfolio
that can be traded

Requires understanding of
liability replicating portfolio
and its dynamics

Significant organisational and

process implications

Use of treasury platforms to

reduce reliance on actuarial
models

Alignment between AM org.

and performance
measurement

Asset management focuses

on adding value through
expertise, relative to
liability benchmark

Active management of risk

profile vs. risk appetite and
risk exposure limits

Provides what-if capabilities

and fast-turnaround response
to market events

Rapid-reaction
hedging capabilities

Can have a significant impact

on overall ECap requirement

Allocates full responsibility for

active investment decisions to
the owner
No cross subsidies
between A&L
Recognises impact of
non-hedgeable risks
Rewards alpha over beta risktaking

Efficient processes and infrastructure

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

Improved risk measurement and modelling

A Liability Driven Benchmark (LDB) framework provides the foundation for efficient ALM

Performance attribution

Risk management

Relative contribution of liability

origination vs. asset management

Transparency of interest rate, credit

and market risks

Distinguish strategic asset allocation

vs. tactical trading and asset
origination

Risk-Minimising Portfolio highlights

investment strategy with minimum of
interest rate risk

LDB
framework

Organizational efficiency

Investment strategy optimization

Clarity of communication between

Insurance Business Units and
Investment Division

Common currency for risk-return

decisions vs. actual liabilities
Ability to incorporate regulatory,
accounting and other constraints

Potential to move toward

dramatically fewer portfolios

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

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The Geneva Association_________________________Etudes et Dossiers no. 340

Rapid-reaction hedging capabilities

Dynamic hedging can significantly reduce economic capital

requirements
Economic value/capital distribution ($MM)

Economic capital Hedged

Single policy issued at time 0 Insurance contract

80

80

60

60

$MM

$MM

Economic capital Unhedged

Single policy issued at time 0 Insurance contract

40

20

Disguised client example

40

20

0
0

12

15

18

Year

12

15

18

Year

Economic
Capital

99th percentile
90th percentile
Average
10th percentile
1st percentile

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

Rapid-reaction hedging capabilities

as well as manage earnings volatility

Economic earnings distribution ($MM)

Economic earnings Hedged

Single policy issued at time 0 Insurance contract

15

15

10

10

5
$MM

$MM

Economic earnings Unhedged

Single policy issued at time 0 Insurance contract

Disguised client example

-5

-5

-10

-10

-15

-15
1

11

13

15

17

19

Year

11

13

15

17

19

Year

99th percentile
90th percentile
Average
10th percentile
1st percentile

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

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The Geneva Association_________________________Etudes et Dossiers no. 340

Alignment between AM org. and performance measurement

The performance of different components of the investment function is isolated via

benchmark portfolios and assessed against the cost of incremental capital

Marked-to-Market performance of the assets

(MVA RMP) (Cost of capital x Economic Capital)

Managing
liabilities better
than
expectations

Insurance
activity
Value
Chain
chain

Beating asset
class benchmarks

Taking good
A/L positions

Benchmark
Market Value of
Liabilities

Performance
measure

Risk-Minimising
Portfolio

(RMP MVL)
(Cost of capital x
Economic Capital)

Strategic Asset
Allocation

Tactical Asset
Allocation

2 (SAA RMP)

3 (TAA SAA)

(Cost of capital x
Economic Capital)

(Cost of capital x
Economic Capital)

Market Value of
Assets

4 MVA

External asset
class
benchmark
Assuming risk
has been
appropriately
constrained

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

Alignment between AM org. and performance measurement

Ultimately, a source of earnings analysis reveals strong, and

weak, performance along the entire value chain

13,000

(350)

575

100

Increase in EV
Interest rate risk
due to interest
reduced liability
carry forward
value
(assets greater
Interest
rates
rise
than liabilities)
reduced asset
values

Opening Economic
Surplus

Interest carry
forward

Investments capital
markets

Liabilities capital
markets

450

40

Disguised client example

10

14,625

Capital
Injection

MVM released
Experience
deviations

Underwriting
profits

Value of new
business

800

MVM release

Other liability

ALM and
Investments:

Marketing and
Distribution:

In-Force
Management:

Loss 241 MM

Profit 443 MM

Profit 49 MM

Net capital flows

Ending Economic
Surplus

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

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The Geneva Association_________________________Etudes et Dossiers no. 340

Efficient processes and infrastructure

Need to chose the right model architecture for ALM analytics that is appropriate for the
organization

Thin client

BUs analyse ALM position

Corporate Centre aggregates

Fat client

BUs measure aggregate exposure

with models

BUs report their individual

exposures

Corporate Centre analyses ALM

position

Corporate Centre determines

and analyses ALM position

Decentralised models tailored

to local business

Local tailoring in measure of

aggregate exposure

Full modelling capability at

Corporate Centre

Low data complexity

Limited data complexity

Little effort at Corporate Centre

High Corporate Centre model

flexibility

Total Corporate Centre control

over model design

High complexity

All effort at Corporate Centre;

no involvement of BUs

Distributed processing

No model flexibility at Corporate

Centre, e.g. for hedge analytics

Modelling required both at

Corporate Centre and BUs

All effort at BUs; relies on

resource commitment

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

The new Efficient ALM can substantially alter the rules of

the game for insurers

Liability management

Responsible for all non-hedgeable risks

created at origination both financial and
non-financial

Performance measure based on origination

profit after CoC

Requires identification and ownership of a

minimum risk PRE portfolio for
WP business

Liability at origination
provides the initial
benchmark value

Alignment of economic, regulatory and

ratings capital requirements

Optimization of diversification benefits

Defining risk budgets

Specifying strategic investment positions

Sets LDB and bears the cost of slippage

Disguised client implementation

which defines the

performance of the liability
management

Strategic Balance Sheet Management reduces

operational and financial (capital) frictions
relative to individual assets, liabilities and
capital requirements

Strategic balance sheet management

10

Asset management

Proactive management of assets relative to Origination of assets can also generate

risk-adjusted profit up front
liability benchmark and CoC encourages
smart investing in advantaged asset
classes

Origination of assets also requires the

definition of risk-adjusted profit at issue

Investment management
performance is determined
relative to the liability-driven
Risk Minimising Portfolio

LON-MOWAB1MKT-146

2007 Oliver Wyman  www.oliverwyman.com

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