Asset Liability Management Intro ACTSC372 For Chen On 2009 07 25 at University of Waterloo PDF

ACTSC 445: Asset-Liability Management
Department of Statistics and Actuarial Science, University of Waterloo
Unit 1 Introduction
What is Asset-Liability Management (ALM)?

ALM can be dened as managing a nancial institution so as to earn an adequate return on funds invested, and to maintain a comfortable surplus of assets beyond liabilities (from Quantitative Risk Management, by McNeil, Frey and Embrechts) ALM is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. (. . . ) It can be dened as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve an organizations nancial objectives, given the organizations risk tolerances and other constraints. ALM is relevant to, and critical for, the sound management of the nances of any organization that invests to meet its future cash ows needs and capital requirements. (From SOAs Professional Actuarial Specialty Guide on ALM) Why ALM? Was initially developed to deal with interest rate risk, which became a major concern in the 1970s, when rates increased substantially and became quite volatile. For instance, insurance companies often sell products that are sensitive to interest rates: an obvious example is the option given to the policyowner to take a loan on the policy at a prespecied interest rate. Before the 1970s, insurers did not expect this option to be exercised very often, except under special personal circumstances. However, when rates went up in the late 1970s and early 1980s, several policyowners decide to exercise this option and invest the loan at a much higher rate than the lending rate. Insurance companies thus needed cash on a much shorter term than anticipated, and often had to borrow money at a very high price to fulll all the loan requests. Here are a two recent actual examples of what can happen when an insurance company does not properly manage its assets and liabilities: In 1997, Nissan Mutual Life, a major insurance company in Japan covering 1.2 million clients and having about 17 billion US$ in assets, was oering individual annuities at a rate of 5 or even 5.5%. The company had a signicant portion of its assets invested in government bonds, and when the rates for those dropped to record (low) levels, the wide gap between the promised return on its liabilities and the one earned on its assets caused the company to go bankrupt (and was the rst japanese insurance company to do so in over 50 years). In 1999, General American Life in the US had issued for 6.8 billion US$ of short-term funding agreements at a quite interesting rate, and with the provision that the investors could ask to be reimbursed within 7 days. When Moodys downgraded the credit rating of General American Life from A2 to A3, several investors asked to be reimbursed. In fact, a few days after the 1
downgrading, a total of 4 billion dollars needed to be reimbursed, which made it impossible for the company to sell its assets quickly enough to satisfy all the reimbursement requests. The company eventually was sold to MetLife. These examples focus on the interest-rate risk, which will be covered in this course, more specically in the two rst parts of the course. But we will also discuss other nancial risks. Namely, we will talk about risk measures that can be applied to a portfolio exposed not only to interest rate risk but more generally to market risk. Then we will discuss credit risk, which is becoming an increasingly important issue in nancial risk management. Before going over the topics discussed in this course in more details, we give a classication of nancial risks that comes from Quantitative Risk Management, by McNeil, Frey and Embrechts: Market risk: risk of a change in the value of a nancial position due to changes in the value of the underlying components on which that position depends, such as stock and bond prices, exchange rates, commodity prices, etc. Credit risk: the risk of not receiving promised repayments on outstanding investments such as loans and bonds, because of the default of the borrower. Operational risk: the risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events. Underwriting risk (for insurance companies): the risk inherent in insurance policies sold, for instance due to changing patterns of natural catastrophes, changes in demographic tables underlying (long-dated) life products, or changing customer behavior. We will study the two rst types of risk here. Another classication sometimes used by actuaries is the one coined by C. L. Townbridge when he was chairperson of the SoA committee on Valuation and Related Matters (C is for contingency). C-1: Asset risk (Risk of asset defaults and decrease in market values). C-2: Mortality and morbidity risks (risk of losses from increase in claims and from pricing deciencies). C-3: Risk of losses due to changes in interest rates (either in the level of interest rates or the shape of the yield curve). C-4: Miscellaneous risks (Accounting, managerial, social and regulatory risks). More details on the four parts of the course are given below. Part 1: Fixed-income securities, duration, convexity, immunization. Fixed income securities form a large class of assets used in ALM. Also, we put an emphasis on bonds and interest rates because an important part of ALM is to deal with interest rate risk. Then an important question to ask in the context of ALM is: what will happen if interest rates change? To answer this, we need to measure the sensitivity of the assets portfolio to interest rates: duration and convexity are two measures that do 2
that. Finally, we will discuss some basic risk management tools, i.e., well try to answer the question: how can we structure our assets portfolio so that it is protected against changes in interest rates. Note: This part of the course will be covered rather quickly, especially topics that have already been covered in ACTSC 231. Part 2: Interest Rate Models, pricing interest-rate derivatives. When we ask in Part 1 what will happen if interest rates change?, if we want to go a little bit deeper, we need to understand how we can expect interest rates to change, i.e., we need to model them. In particular, good models are required to price interest-dependent securities. Here we look at a few simple stochastic models. We will start with discretized versions of these models, where derivatives related to interest rate (like callable bonds) can be priced using a binomial tree. If you have taken ACTSC 446, this part will be very familiar to you. But we will also look at continuous-time models, and describe techniques that can be used to price interest-rate derivatives in that case, and will see that these techniques are more exible and ecient that binomial-tree type methods. Part 3: Risk Measures. Duration and convexity focus on interest-rate risk. To measure a portfolios exposure to a wider range of risks, other measures have been dened. One of them is value-at-risk, which well study here. We will also talk about other measures, like conditional tail expectation (or TailVar), and discuss methods for computing these quantities. In particular, we will talk about the use of simulation and importance samplingprobably familiar if you have done STAT 340for this type of computation. We will also make sure to cover models that go beyond the simple multinormal linear case. Part 4: Credit Risk Credit risk has to do with the risk that a borrower will not pay back a loan to the lender. With the mortgage crisis in the US, this is an area of study that has become very important. We will talk about dierent models that can be used to study credit risk, and the statistical and computational techniques that go with them. In particular, we will talk about copula models for credit risk.
ALM in practice
Large corporations, insurance companies, and nancial institutions typically perform some form of risk management. To give a bit more insight on this, here are a few facts taken from the Results of the Survey on Asset-Liability Management Practices of Canadian Life Insurance Companies (May 2002): 86% of all companies surveyed view interest rate risk as deemed material for their company, and 80% have a formal process to manage this risk. More than two thirds of medium and large companies have an independent ALM function. In large companies with an independent ALM function, up to 20 persons are working on ALM. 79% of all companies use modied duration as a risk metric, 51% use convexity; 57% of all large companies use value-at-risk. Second most cited future goal is to implement stochastic scenario generator.

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ACTSC 445: Asset-Liability Management

Department of Statistics and Actuarial Science, University of Waterloo

What is Asset-Liability Management (ALM)?

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