Asset Liability Management in Life Insurance Industry in IndiaIssues and concerns

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Asset Liability Management in Life Insurance
Industry in IndiaIssues and concerns

• Dr. R Kannan
• Member (Actuary)
• I R D A

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Definition of ALM

• The SOA defines ALM as the practice of managing
  a business so that decisions on assets and
  liabilities are coordinated or more broadly
  ..the ongoing process of formulating
  implementing monitoring and revisiting strategies
  related to assets and liabilities in an attempt
  to achieve financial objectives for a given set
  of risk tolerance and constraints

CILA Mumbai AUG 28, 2009
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Why we must consider ALM?

• Mismatching could have serious implications for
  the financial viability, as evidenced by collapse
  of many life insurers
• Prudent management of ALM accounts for a good
  reward in RBC
• ALM answers the strategic questions, viz.,
• availability of adequate capital for solvency in
  stressed scenario
• how to make a trade off between risk and return
• what is the optimal growth of premium, given the
  risk appetite
• adequacy of reinsurance arrangements
• optimal use of risk mapping and evaluation of
  alternative strategy

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Factors contributed to the evolution of ALM
techniques

• Enhanced computing power
• Deepening and broadening of financial markets and
  consequent availability of varieties of financial
  instruments
• Competitive forcesoffering of high risk options,
  riskier investment portfolios, more
  interest-sensitive products, greater guarantees
  on return, hence higher risk for insurers
• Regulatory restrictions/ guidelines on investment
• Taxation of financial instruments
• Market based self-regulation of asset related
  risks

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Actuarial categorization of risks
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Macro relationshipsome basic facts

• A rise in the required yield to maturity reduces
  the price of the fixed income securityhence a
  downward sloping curve exists between market
  value and yield to maturity
• The longer the maturity of a fixed income
  security, the greater its fall in price and
  market value due to an increase in the interest
  rate.
• The decrease in the value of the security
  increases at a diminishing rate for any given
  increase in interest rate

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Macro relationshipsome basic facts (contd.,)
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Maturity method

• In the maturity method, if the maturity of assets
  is greater than maturity of liabilities, any
  change in the interest rate will affect the value
  of assets more than liabilities. Hence maturity
  method, considers only direction and magnitude
  of the maturity and does not consider cash flows.
  Hence the evolution of the ALM pays attention
  towards
• Macaulay duration
• Modified duration
• Option adjusted duration
• convexity

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Macaulay Duration
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Modified duration

• Macaulays duration computes the present value
  weighted average time to maturity of the cash
  flows of a certain financial instrument.
• The duration method is more appropriate than a
  maturity method to measure interest rate risk
  because it not only takes into account the
  maturity but also the timing of the cash flows of
  the instrument or portfolio exposed to interest
  rate risk. It measures the "average life" of the
  asset or liability.

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Modified duration

• The modified duration of financial instruments is
  a measure of price sensitivity of a fixed set of
  cash flows to small changes in the single
  interest rate.
• The higher the measure of duration, the more
  sensitive (elastic) is the value of the financial
  instrument to changes in interest rates.

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Option adjusted duration

• The option-adjusted duration, like the modified
  duration, is a measure of price sensitivity. The
  difference is that optionadjusted duration is a
  much more accurate measure of price sensitivity
  if the cash flows depend upon the path that
  interest rates take. This is nothing but
  elasticity of price with respect to the interest
  rate
• Option-adjusted Duration -d Price/ di
• Price
• This expresses how much the price will change
  (dPrice) as a result of small changes in interest
  rates (di), and is expressed in terms of a ratio
  by dividing by the beginning price.

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Option adjusted duration

• The duration of a bond is always smaller than its
  maturity. The only exception is with a
  zero-coupon bond where its duration and maturity
  are equal.
• Increasing the coupon rate while keeping its
  maturity and the yield constant will decrease the
  duration of the bond. Bonds with higher coupons
  distribute relatively more cash flows earlier
  decreasing the average life of the bond.

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Convexity

• Convexity is defined as the second derivative of
  price with respect to interest rates divided by
  the price, and is a measure of how the duration
  changes as interest rates change.
• A positive convexity is a good attribute for an
  asset to have, for example if the interest rate
  increases by 100 basis points the asset will gain
  more value than if the interest rate falls by the
  same amount. Liabilities, on the other hand,
  benefit from negative convexity

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Immunization

• Immunization seeks to match interest rate
  sensitivities of assets and liabilities. By so
  doing, the company will hopefully be protected
  from a change in interest rates.
• We look for an asset portfolio which has
  sufficient value to fund the liabilities, but we
  relax the requirement of cash-flow matching.
  Instead, we require that the sensitivity to
  changes in interest rates is equal on the asset
  and liability sides. That is, we immunize against
  interest rate changes.

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Reddington immunization rule

• NPV of assets NPV of liabilities
• Duration of assets duration of liabilities
• The first two conditions imply that the
  variability of liabilities should be small
• Convexity of assets gt convexity of liabilities

CILA Mumbai AUG 28, 2009
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Various steps in the ALM

• Portfolio segmentation by product line
• Cash-flow management
• Portfolio gap analysis, including maturity
  analysis and interest rate sensitivity analysis
• Simulation analysis, including cash flow testing
  and dynamic solvency testing
• Optimization analysis
• Hedging strategies for investing

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Duration
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Issues at hand

• Single premium productswhat difference between A
  and L on economic basis ?
• Participating liabilityproportionate change in
  assets is slightly more than that of liabilities?
• ULIPsno duration match required for unit
  reserves?
• Assets valued at book value liabilities at
  consistent basisis it appropriate ?
• Contradiction with GN2 if changes would result
  in a change 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 as
  contingency margin, having regard to the
  consequences should the provision prove
  insufficient

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Issues at hand ( contd.,)

• 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?
• Monitor the movement of free assets?
• Projection of capital requirementworking out of
  resilience capital for the future?
• Sensitivity of the companys financial strength
  to the following
• New business volume
• Business mix
• Expense control
• How to avoid over prudent ?

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• Thank you