Asset Liability Management

Asset Liability Management Tools,
Techniques and Assumptions
Southeastern Actuaries Conference Spring Meeting

Greg Roemelt
June 17, 2010
2010 Towers Watson. All rights reserved.
Why Asset Liability Analysis is important
Interest rate risks are embedded into many insurance company

products and also investments
General account annuities

Minimum guarantees
Book value surrenders
Universal life secondary guarantees
Long term care
Callable assets
Important to recognize the costs and risks of the options insurance

companies are writing
We only get one scenario
towerswatson.com
2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
C:\sac.ppt
ALM Tools
Cash flow analysis
Financial statistics
Duration
Convexity
Valuing embedded liability options
Asset liability efficient frontier analysis
Benchmark Portfolios
Replicating Portfolios
towerswatson.com
C:\sac.ppt
Sample ALM Model
Liabilities
Single premium deferred annuities
Issued
$454 million reserve

$415 cash surrender value
$454 fund value
over last 8 years
Guaranteed credited rates either 3% or 4%

7% initial surrender charge grading to zero over 7 years
Assets
$216 million corporate bonds
$64 million mortgage passthroughs
$174 million CMOs (Sequentials and PACs)
towerswatson.com
C:\sac.ppt
Behavior Assumptions
Assets bonds calls and mortgage prepayments
Callable Bonds
Firms make irrational decisions
Delay calling in-the-money bonds

Call out-of-the-money bonds
Residential mortgage pre-payments

Outside models (ADCO, BondEdge)
Single factor assumptions
Impact of economic environment
Commercial mortgages
Yield maintenance or make-whole provisions
towerswatson.com
C:\sac.ppt
Behavior Assumptions
Liability - Excess Lapse formulas
Typically Exponential Formulas

Mult * (Comp Cred - Threshold)exponent
Surrender charge adjustment

Lower exponent, higher multiple
Considerations in setting parameters

Product
Distribution System
Market
towerswatson.com
Considerations in setting Competitor Rate
C:\sac.ppt
Excess Lapse Function

100%
90%
80%
Mult = 2.0
70%
Exp = 2.5
60%
50%
40%
30%
20%
Mult = 5.0
10%
Exp = 1.5
0%
0%
1%
towerswatson.com
2%
3%
4%
5%
C:\sac.ppt
Cash Flow Analysis
Comparing expected cash flows from assets and liabilities
Should include all cash flows
Assets
Coupon
Calls/Prepayments
Adjusted for defaults
Liabilities
Premium
Benefits
Expenses
Taxes
Shareholder dividends?
towerswatson.com
C:\sac.ppt
Cash Flow Projections Level Scenario

200
180
160
140
120
100
80
60
40
20
0
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Year
Asset Cash Flows
towerswatson.com
Liability Cash Flows
C:\sac.ppt
Cash Flow Projections Pop Up Scenario

200
180
160
140
120
100
80
60
40
20
0
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Year
Asset Cash Flows
towerswatson.com
C:\sac.ppt
10
Cash Flow Projections Pop Down Scenario

200
180
160
140
120
100
80
60
40
20
0
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Year
Asset Cash Flows
towerswatson.com
C:\sac.ppt
11
Net Cash Flows Stochastic Scenarios

Maximum, Minimum, 25 and 75 Percentiles
300
250
Net Cash Flow
200
150
100
50
0
-50
-100
2010
2011
2012
2013
2014
Projection Year
towerswatson.com
C:\sac.ppt
12
Duration and Convexity
Duration
Negative of the first derivative of the price function with respect to

interest rates
Effective Duration = (P- - P+) / 2P0 y
Where
P0 = Bond price.
P- = Bond price when interest rate is incremented
P+ = Bond price when interest rate is decremented
y = change in interest rate in decimal form
towerswatson.com
C:\sac.ppt
13
Duration and Convexity
Convexity
Second derivative of the price function with respect to interest

Effective Convexity = (P- + P+ - 2P0) / 2 * P0 (y)2
Where
P0 = Bond price.
P- = Bond price when interest rate is incremented
P+ = Bond price when interest rate is decremented
y = change in interest rate in decimal form
towerswatson.com
C:\sac.ppt
14
Calculating Duration and Convexity
Liabilities
Project liability cash flows over arbitrage free stochastic scenarios
Use either spot rates or spot rates plus asset OAS to discount cash flows
Calculated P- and P+ by increasing and decreasing starting yield curve
Issues:
Future premiums (especially on flexible premium products) can lead to unusual
results
towerswatson.com
C:\sac.ppt
15
Price Function for Assets and Liabilities
Market Value ($ millions)
165
160
155
150
145
140
135
130
-150
-100
-50
50
100
150
Interest Rate Change (bp)

Assets
towerswatson.com
Liabilities
C:\sac.ppt
16
Asset Duration and Convexity

Market Value ($
millions)
Duration
Convexity
Plus 100 bp
144.3
5.7
3.9
Plus 50 bp
148.5
5.4
-58.2
Base Line
152.4
5.0
-65.9
Minus 50 bp
156.1
4.2
-198.9
Minus 100 bp
159.0
3.4
-95.4
Scenario
towerswatson.com
C:\sac.ppt
17
Liability Duration and Convexity

Market Value ($
millions)
Duration
Convexity
Plus 100 bp
143.8
2.2
-66.9
Plus 50 bp
145.3
1.8
-93.7
Base Line
146.5
1.3
-117.8
Minus 50 bp
147.2
0.9
-12.7
Minus 100 bp
147.8
1.0
33.0
Scenario
towerswatson.com
C:\sac.ppt
18
Valuing Embedded Liability Options
Example Partial Free Withdrawals
Project average distributable profits with partial free withdrawals over

stochastic scenarios (base line)
Remove partial withdrawals and adjust credited rate until average

distributable profits equal base line
Difference in credited rate is the value of partial withdrawal benefit
Analysis can be extended to any embedded liability option
towerswatson.com
C:\sac.ppt
19
Asset Liability Efficient Frontier Analysis
Extension of the efficient frontier from the capital asset pricing model
(CAPM)
CAPM uses the rates of return on assets and the volatility of those
returns to determine optimal portfolios
Asset liability efficient frontier analysis extends this concept to test

various ALM strategies
towerswatson.com
C:\sac.ppt
20
10
Methodology
Define Risk and Return
Anything that can be calculated from the projection output

Risk
Volatility
Number of scenarios with negative present values
Number of periods where surplus is negative
Return
Average present value of distributable profits
Number of scenarios where assets under management exceed x dollars
towerswatson.com
C:\sac.ppt
21
Methodology
Develop a robust set of strategies
Investment
Crediting
Product design
Run stochastic projections for each strategy
Plot risk and return statistics
Determine efficient strategies
Decide on acceptable levels of risk and return
towerswatson.com
C:\sac.ppt
22
11
Sample
Define 9 different reinvestment strategies
50/50 5 year A and 5 year BBB corporate bonds
High quality (AAA) corporate short
High quality (AAA) corporate long
BBB corporate short
BBB corporate long
100% PAC CMOs
100% Passthroughs
50% PAC CMOs, 50% A corporate long
50% AAA corporate short, 50% BBB corporate long
towerswatson.com
C:\sac.ppt
23
Sample
Risk and return statistics
Return
Risk
Average present value of distributable profits at 12%
Percentage of quarters with negative statutory profits
towerswatson.com
C:\sac.ppt
24
12
PV Distributable Profits
Asset Liability Efficient Frontier
16
14
12
G
B
10
8
6
4
2
0
0.0%
H
F
0.5%
1.0%
1.5%
% of Quarters with Negative Profits

towerswatson.com
C:\sac.ppt
25
Advantages of ALEF Methodology
Measure the impact of different strategies on key financial metrics
Definition of risk and return consistent with company objectives
Not limited to standard definitions
Allows for stochastic processes for any assumption
towerswatson.com
C:\sac.ppt
26
13
Benchmark Portfolios
Used to evaluate investment performance
Historical have been based on broad, market wide indices
Lehman (now Barclays) Aggregate index for bonds
S&P 500 index for equities
More recently, companies have been developing customized

benchmarks
towerswatson.com
C:\sac.ppt
27
Developing Customized Benchmark Portfolios
Quality target
Sector allocation
Option risk
Liquidity
Regulatory constraints
Duration targets
towerswatson.com
C:\sac.ppt
28
14
Sample Indices Barclays Family of Indices

Index
Duration
Yield
U.S. Treasury
5.32
2.01
Short Treasury
0.41
0.15
U.S. Treasury: U.S. TIPS
4.23
3.02
U.S. Credit
6.32
4.29
1-3 Yr Credit
2.03
2.28
U.S. Intermediate Credit
4.38
3.70
U.S. Long Credit A
12.5
6.01
U.S. Mortgage Backed Securities
2.92
3.49
U.S. Corporate High Yield
4.44
9.48
Municipal Bond
8.24
3.48
towerswatson.com
C:\sac.ppt
29
Benchmarks by Line of Business
Linear combination of appropriate benchmarks
Criteria is desired quality, duration and asset mix
Can be aggregated across company or used on an LOB basis
towerswatson.com
C:\sac.ppt
30
15
Replicating Portfolios
Definition
Portfolio of marketable securities developed to replicate the characteristics of

a group of liabilities
towerswatson.com
C:\sac.ppt
31
Use of Replicating Portfolios
Performance management
Investment strategy benchmarks
Capital and value calculations
Solvency II
Economic Capital
ALM and Risk Management
towerswatson.com
C:\sac.ppt
32
16
Process
Analyze liability characteristics
Cash flows
Market value sensitivities
Select securities for replicating portfolio
Zero coupon bonds
Credit default swaps (to add risk spread)
Call and put options (to capture optionally of liabilities)
Use optimization techniques to select the best fit portfolio
More art than science
towerswatson.com
C:\sac.ppt
33
C:\sac.ppt
34
ALM Assumptions
Asset Options
Liability Options
towerswatson.com
17
Callable Bonds
Finance theory has shown optimum time to call bond is when it is

first in the money
As usual, reality does not follow theory
Firms make irrational decisions

Delaying in-the-money calls
Calling an out-of-the-money bond
Implications for asset projection models
towerswatson.com
C:\sac.ppt
35
Empirical Research
King and Mauer (2000) examined factors affecting the timing of

calls on non-convertible bonds
Three groups:
Called immediately when bond went into the money
Called when bond was out of the money
Delayed call after bond went into the money
Significant cost to delaying call
towerswatson.com
C:\sac.ppt
36
18
Factors Impacting In The Money Calls
Opportunity cost of leaving bond outstanding (+)
Amount of time bond has been in the money (+)
Slope of the yield curve (+)
towerswatson.com
C:\sac.ppt
37
Implications For Setting Call Assumptions
The more calls in are the money, the more likely the bond is to get
called
The longer a bond is in the money, the more likely it is to get called
Out of the money bonds do get called
towerswatson.com
C:\sac.ppt
38
19
Policyholder Behavior Assumptions
Flip side to call/prepayment assumption
Calls and prepayments are the exercise of a call options, usually in a down
interest rate environment
Interest rate driven surrenders are the exercise of put options, usually in an
up interest rate environment
Usually vary by product type
Should recognize impact of distribution on policyholder behavior
towerswatson.com
C:\sac.ppt
39
Types of Policyholder Behavior Assumptions
Surrenders
Partial withdrawals
Flexible premium patterns
Higher or lower
Other
towerswatson.com
C:\sac.ppt
40
20
Typical Formulas
Usually compare credited rates with a defined competitor rate
Competitor rates should reflect competition for funds in the market
Other insurance products
Money market accounts
CDs
Include an adjustment for the impact of surrender charges
Usually of the form:

Dynamic Lapse = Multiplier * .01
* [100 * (Credited Rate Competitor Rate )]Exp
* (1 CSV/Fund Value)
towerswatson.com
C:\sac.ppt
41
Excess Lapse Formulas - Parameters
Historically, for deferred annuities, multiplier and exponents of 2 and 2
Recently, trend is towards higher multipliers and lower exponents
reducing the exponent reduces the steepness of the lapse curve
towerswatson.com
C:\sac.ppt
42
21
Excess Lapse Parameters
Since the early 80s, interest rates have exhibited a downward or level
trend
Very few environments for evaluating excess lapse formulas
Even with more experience, variety of product features and distribution

systems will complicate assumption development process
towerswatson.com
C:\sac.ppt
43
Using mortgage prepayments to estimate deferred

annuity excess lapses
Extensive data on mortgage prepayments is available
Although not perfectly analogous, prepayments and excess lapses

should exhibit similar patterns
Surrender charges can be viewed as cost of refinancing
Savings on refinanced mortgage rate similar to increased yield on

replacement annuity
towerswatson.com
C:\sac.ppt
44
22
Mortgage Refinance Decision - Simple
Years to break even
Cost / monthly savings / 12
Example:
6% mortgage, $300,000 outstanding, 25 years remaining

Payment is $1,932
Refinance opportunity
5%, 30 year, $1,610 monthly payment
Cost: $2,000
Breakeven is about 7 months
Ignores additional 5 years worth of payments
towerswatson.com
C:\sac.ppt
45
Mortgage Refinancing Decision - Actuarial Approach
Calculate present values under both options
Select option with lower present value
towerswatson.com
C:\sac.ppt
46
23
Mortgage Refinancing Efficiency Ratio
Apply this analysis to historical data
May have to go back to pre housing bubble for meaningful data
Develop a function that relates likelihood of refinancing to based on

efficiency ratio, i.e.
PV of costs after refinance
PV of cost before refinance
towerswatson.com
C:\sac.ppt
47
Extension to Excess Lapse Assumption
Use efficiency ratio function to develop excess lapse formula
Differences between annuity surrenders and mortgage refinancing
Market conditions
Tax impacts
Surrender charges
towerswatson.com
C:\sac.ppt
48
24
Final Thoughts
ALM analysis performed over multiple scenarios actual results occur

in one scenario
Averages are important, but so are distribution of results
Results in the tails can provide useful insights
ALM is heavily dependent on assumptions

Policyholder behavior
Asset calls and prepayments
Good data not always available

Use best estimate, but useful to sensitivity test
The world is always changing and we only have a rear view mirror
towerswatson.com
C:\sac.ppt
49
Contact Information
Greg Roemelt
Towers Watson
71 S. Wacker Drive
Chicago, IL 60606
312.201.6317
Greg.Roemelt@TowersWatson.com
towerswatson.com
C:\sac.ppt
50
25

Asset Liability Management

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Asset Liability Management

Uploaded by

Copyright:

Available Formats

Asset Liability Management Tools,

Techniques and Assumptions

Southeastern Actuaries Conference Spring Meeting

2010 Towers Watson. All rights reserved.

Why Asset Liability Analysis is important

Interest rate risks are embedded into many insurance company

General account annuities

Universal life secondary guarantees

Long term care

Important to recognize the costs and risks of the options insurance

We only get one scenario

Cash flow analysis

Valuing embedded liability options

Asset liability efficient frontier analysis

Sample ALM Model

$454 million reserve

Guaranteed credited rates either 3% or 4%

Assets bonds calls and mortgage prepayments

Delay calling in-the-money bonds

Residential mortgage pre-payments

Liability - Excess Lapse formulas

Typically Exponential Formulas

Surrender charge adjustment

Considerations in setting parameters

Considerations in setting Competitor Rate

Excess Lapse Function

Cash Flow Analysis

Comparing expected cash flows from assets and liabilities

Should include all cash flows

Cash Flow Projections Level Scenario

Liability Cash Flows

Cash Flow Projections Pop Up Scenario

Liability Cash Flows

Cash Flow Projections Pop Down Scenario

Liability Cash Flows

Net Cash Flows Stochastic Scenarios

Net Cash Flow

Duration and Convexity

Negative of the first derivative of the price function with respect to

Duration and Convexity

Second derivative of the price function with respect to interest

Calculating Duration and Convexity

Project liability cash flows over arbitrage free stochastic scenarios

Calculated P- and P+ by increasing and decreasing starting yield curve

Price Function for Assets and Liabilities

Market Value ($ millions)

Interest Rate Change (bp)

Asset Duration and Convexity

Liability Duration and Convexity

Valuing Embedded Liability Options

Example Partial Free Withdrawals

Project average distributable profits with partial free withdrawals over

Remove partial withdrawals and adjust credited rate until average

Difference in credited rate is the value of partial withdrawal benefit

Analysis can be extended to any embedded liability option

Asset Liability Efficient Frontier Analysis

Asset liability efficient frontier analysis extends this concept to test

Define Risk and Return

Anything that can be calculated from the projection output

Develop a robust set of strategies

Run stochastic projections for each strategy

Plot risk and return statistics

Determine efficient strategies

Decide on acceptable levels of risk and return