Chapter 19 Investment Principles and Asset Liability Matching PDF

# Chapter 19: Investment Principles and Asset Liability Matching ## Syllabus Objectives * Investment and asset liability management (ALM) considering: * the principles of investment * the asset-liability matching requirements of a general insurer * how projection models may be used to...

# Chapter 19: Investment Principles and Asset Liability Matching ## Syllabus Objectives * Investment and asset liability management (ALM) considering: * the principles of investment * the asset-liability matching requirements of a general insurer * how projection models may be used to develop an appropriate investment strategy. ## Introduction This chapter examines the important issues relating to a general insurer setting an appropriate investment strategy. * **Section 1** looks at the effect the liabilities have on the choice of assets. * **Sections 2 and 3** discuss the impact of the insurer's free assets and non-investible funds when setting the investment strategy. * **Sections 4-6** consider the importance of projecting future cashflows when determining an appropriate investment strategy, and the need to assess the sensitivity of these projections to changes in our model assumptions. * **Sections 7-9** discuss how our cashflow projections and resulting investment strategy also need to allow for solvency requirements, other regulatory requirements, and the insurer's overall company objectives. * **The final sections** of this chapter discuss asset liability modelling. This is a useful tool to aid understanding and develop an investment strategy. ## The Effect of the Liabilities on Asset Selection ### Features of General Insurance Liabilities The main features of the liabilities of a general insurer are described earlier in the course material. When considering which investments to hold the general insurer needs to take account of the key investment principles applicable to all investors. The prime objective in relation to the investment of the assets supporting these liabilities is to maximise investment return whilst meeting all contractual obligations and ensuring the risk against not receiving the return is within the company's tolerance. The implication for asset choice is that the characteristics of the assets should match those of the liabilities: * Term of the liabilities * Amount of the liabilities * Nature of the liabilities (ie fixed or real) * Currency of the liabilities. In this section, we refer to liabilities using the example of the main liabilities of a general insurer: the insurer's technical provisions. In practice, of course, an insurer will have other liabilities. However, the investment considerations relating to these other liabilities will in general be less significant, because they are smaller, shorter-term, and much more predictable. ### Outstanding Term of the Investments The interval between when an insurer receives a premium and when it pays out any associated claim is important because part of the premium can be invested over that time. **Question:** Explain why in the previous sentence it says only 'part of the premium can be invested'. **Solution:** The rest of the premium is used to meet initial expenses, eg administration costs and commission. The assets held to cover the technical provisions need to be selected with the aim of ensuring that the pattern of the income from the assets corresponds reasonably closely to that of the outgo on the liabilities (the outgo being the payment of claims). In other words, we need to match assets and liabilities closely as described earlier. A wide range of classes of insurance give rise to a short interval between receipt of premium and payment of most claims. These short-tail classes will make it necessary to hold cash on deposit or very short-dated assets. For business with a long average period between receipt of premiums and payment of claims, there is the opportunity to make longer-term investments. Long-tail liability classes would be prime examples of where this would be the case. The advisability of investing money is twofold: * **Matching assets to liabilities by term:** This will tend to reduce the vulnerability of the insurer to adverse effects of changes in interest rates. * **Invested assets are likely to provide higher yields than cash on deposit:** If the insurer is to be able to charge competitive premium rates, it will need to obtain a reasonably good return, at least comparable with those of other insurers, on the investment of its assets backing the technical provisions. In other words, the higher expected return on long-term assets will allow the insurer to reduce its premium rates. Medium-dated fixed-interest stocks, index-linked stock where available and, to a very limited extent, equities and real estate are the likely choices of assets to support longer-tail insurance classes. **Question:** Explain why equities are likely to be used to only a very limit extent. **Solution:** Equities have volatile market values - there is the risk that the insurer needs to realise the investment sooner than expected, at a time when market values are depressed. Equities also carry a higher security risk - in the case of company failure, equity ranks behind bonds. ### The Influence of Inflation on Investment Policy The final payment amount for the majority of claims will depend on when they are settled as the claim amount will be subject to inflation. For example: * **Price inflation:** This will affect the costs of property repair and replacement costs. * **Earnings inflation, medical inflation and judicial inflation:** This will affect bodily injury claims for liability business. The expenses of settling claims will also be subject to inflation. **Question:** Explain what the likely relationship is between price inflation and: * Earnings inflation * Judicial inflation. **Solution:** * **Earnings inflation** will exceed price inflation in the long run. * **Judicial inflation** will also exceed price inflation, and it can be very much in excess of price inflation. Both equity shares and property are real investments and may increase at a rate in excess of price inflation. The income and capital values generated by investment in equity shares and property may, in the long term, tend to keep pace with claims inflation, but may be subject to considerable fluctuations in the short term. However, certain contract types such as personal accident and fidelity guarantee may have fixed claims amounts. In these cases, inflation will be a minor issue and the appropriate investment policy will lean more towards fixed-interest vehicles. Further classes may have benefits where ‘fixed’ amounts are linked to inflation, for example, household insurance where cover is on a new-for-old basis. This should also be considered when setting the investment policy. ### How Liquid do The Assets Need to Be? An asset is liquid if it is very close to cash. Liquid assets will either mature in the very short term or have very stable values so have a predictable sale value. If an insurer is writing business in a class that has a history of producing widely fluctuating levels of claims, it will be wise to maintain access to ready funds. Even with reinsurance protection, the insurer will still be left with the obligation to pay the gross claims, perhaps far in advance of making recoveries from reinsurers. The short-term and highly uncertain nature of a typical general insurer's liabilities means that the marketability and liquidity of the assets are important factors in investment policy. ## The Effect of the Free Assets on Asset Selection An insurance company's assets in excess of its liabilities (known as its 'free assets') will be available for investment with the aim of maximising the long-term return for the shareholders. The investment of the free assets will also reflect the insurer's attitude to risk and its future plans, e.g. to use this money to expand the business or take over another insurer. The way in which an insurer chooses to invest the free assets will be influenced by the size of the free assets relative to liabilities, and by any regulatory requirements to which the insurer is subject. However, size should not be measured only in absolute terms. An insurer also needs to compare the size of the assets available to: * The size of the technical provisions * Liquidity from the premiums written each year * The absolute size of the liabilities the insurer is subject to at any time * Any regulatory capital requirements. An insurer will want to maintain its free reserves so that it can demonstrate to policyholders, brokers and any regulatory body that it will be able to meet future liabilities. The greater the free reserves, the greater the investment freedom. ### Example 1: Company with Low Free Reserves * **Value of liabilities:** £400m * **Value of assets:** £410m The company has very little investment freedom if it wants to ensure the value of its assets remains higher than the value of the liabilities. The company must avoid assets that have volatile market values, so only a very small percentage should be invested in equities, long-dated bonds, property, etc. Almost all the funds should be in short-dated investments with secure values. Note that in practice, companies will be required to hold a minimum solvency margin, in excess of the value of its liabilities. ### Example 2: Company with Reasonable Free Reserves * **Value of liabilities:** £400m * **Value of assets:** £500m This company has some investment freedom, but must still monitor the value of its assets carefully. The remainder of the assets might be invested to maximise return. Some volatility of market value of the ‘high-risk’ assets should not cause too much concern. ### Example 3: Company with Very Large Free Reserves * **Value of liabilities:** £400m * **Value of assets:** £950m The company has enormous investment freedom. It could choose to mismatch to a very large extent, without jeopardising its solvency. In summary, a company with large free reserves can pay more attention to maximising expected return. **Question:** Suppose that, for the company in the first example above, the given value of liabilities is on a very cautious basis (ie with significant margins in the valuation of outstanding claims reserves). Explain how this has affected the investment policy, and suggest whether the investment policy would have been any different if the liabilities had been assessed on a ‘best estimate’ basis **Solution:** If the value of the liabilities had been, say £300m on a best estimate basis, then we might have proposed an investment policy of £300m in matching assets, and had £110m invested more aggressively with the aim of maximising returns. This is very different from the conservative investment strategy that we recommended when the liabilities were valued with significant margins. To maximise the return on its free assets, the insurer will normally invest long term in equities. It might also invest directly in property if the funds available for investment are sufficiently large for it to put together a diversified portfolio. However, it should be remembered that property suffers from poor liquidity and marketability which would mean it is inappropriate to hold a large portion in this asset class, in case funds are required quickly. An alternative would be to invest indirectly in property, by means of a property fund. ## Non-investible Funds Not all the assets of a general insurer will be available for investment; for example, monies held by: * Agents / brokers * Policyholders * Reinsurers These funds can be a large proportion of the total assets, although it will vary between companies depending on several factors, such as: * The mix of business * The arrangements with the various other parties, including reinsurers * Debt collection efficiency. In effect, these non-investible funds are tangible, short-term assets. Therefore, the insurer may decide that a smaller proportion of its other, investible, assets needs to be invested short. However, these assets are not easily realisable. In other words, they are subject to the risk of default. The risk of non-recovery may cause the insurer to look for greater security from the investible assets and to set aside provisions for bad debts when considering these debtor-type assets. ## Estimating The Liability Outgo in Future Time Periods When choosing an appropriate investment strategy the general insurer will need to have a good understanding of how liabilities will arise in the future. The scope of the liability outgo projections needs to be decided. Two fundamental choices are whether to include: 1. Premium income and outgo relating to business that will be written after the accounting date, which will depend on whether the exercise is to assess ongoing profitability, solvency and investment policy. 2. Only the liability outgo relating to the existing liabilities (for business already written), which will depend on whether the exercise is to determine assets suitable for matching to existing liabilities. The aim is to project, on a best estimate basis, the overall liability outgo in each future time period. A best estimate basis will be used as we need a realistic view of the likely outgo when determining the investment strategy. Testing can then be carried out on different bases to check that the strategy is robust. The overall liability outgo can be calculated from the separate items of income and outgo as: * Total gross claim payments to be made (gross of reinsurance) * Reinsurance and other recoveries to be received * Expenses to be paid * Outstanding premiums to be received * Tax and dividend payments to be made Each of these items can be projected in the same way as for calculation of technical provisions. However, it is the individual period-by-period projections that are important. Calculations done on a monthly or quarterly basis can take account of any seasonal effects if this is deemed important. It is best to split the business into relatively homogeneous risk groups, for example, by class, type of claim within class and currency. Care needs to be taken however that the data does not start to lack credibility if the volume of data in each risk group is lower. ### Claim Payments and Recoveries Claim payments are almost always the most significant item of the liability outgo. The projection must include: * All future payments in respect of unsettled reported claims * IBNR and reopened claims * Claims that will emerge from unexpired risks. Ideally, the claim payments should be treated as gross of reinsurance and other recoveries, as the timings of these recoveries do not usually coincide with those of the claim payments. Reinsurance and other recoveries should be included separately as an offset to the liability outgo, allowing for when they are expected to be recovered. Whatever method is used, results of projected cashflows in individual time periods will likely be subject to considerable uncertainty. If necessary, claims could be projected net of reinsurance recoveries, but with a margin to allow for recovery delays and defaults. ### Expenses The expenses relating to handling the claims can be allowed for either explicitly or implicitly. For example, an implicit allowance may just be an additional percentage loading to the claim payment. Other office expenses would usually need to be projected, although this would depend on the precise purpose of the projections. * **Expenses relating to investment** will normally be considered as an offset to the projection of the asset proceeds. ### Premium Income Premiums will usually be taken gross of reinsurance premiums but net of commission, and possibly also net of internal initial administration expenses. Any premiums due to reinsurers would then be deducted. Where new business and renewals are not included, allowance for outstanding premiums should be relatively easy because most of the cashflows are likely to emerge within a relatively short time period. **This assumes that the business written is annual.** However, when including new business and renewals, allowance will need to be made for: * Expected rates of premium growth (and profitability) in the light of the company's business plan * Each class of business * The competitive position * The effect of the insurance cycle. These factors obviously also affect the projection of claims and expenses relating to the new business and renewals. **This can be an area of significant uncertainty.** In either case, the premium income should be considered separately by source of business to allow correctly for delays and acquisition costs. ### Tax and Dividend Payments Some attempt may also be made to project future tax and dividend payments. Other than in relation to the next few months, assumptions will be needed about future investment returns, tax rates and dividend philosophy. These components of liability outgo can only be assessed in tandem with the projection of the asset proceeds and profitability of the company (as dividends and tax are generally driven by profitability). ## Estimating the Investment Income in Future Time Periods The process of estimating income from the investments is relatively straightforward compared with the equivalent process for the liabilities. For example, the income due from fixed-interest stock is known with certainty, notwithstanding any default risk. However, some assumptions such as future inflation rates, dividend yields and interest rates, will have to be made for other investment classes. An allowance also needs to be made for any capital proceeds, eg the redemption payments on any maturing bonds, during the period of consideration. For all types of investment, it is important to make allowance for the expenses of investment. Investment expenses are usually a negative adjustment to projected asset proceeds. The projections will need to make allowance for the future volatility of capital values and investment income. ## Sensitivity of Cashflow Results to Changes in Assumptions It is important to understand how the liabilities and assets react both in isolation and most importantly relative to each other if different assumptions are used. A stochastic model can give an indication of the sensitivity of both the assets and the liabilities to changes in the assumptions. However, in practice many companies perform a large number of deterministic simulations at the sensitivity testing stage. Parameter values are not chosen at random, but a large number of runs are performed where each one is based on a different combination of parameter values drawn from a large collection of possible sets of best estimates. The range of assumptions used can reflect the level of uncertainty of liabilities and volatility of assets. If it is discovered that small changes to the assumptions produce dramatic alterations to the net cashflow, the insurer will know that more substantial positive cashflow will be needed in the overall model to protect against the adverse effect of such changes. ## Solvency Requirements Where market values are used, the solvency position is directly influenced by the volatility of the values of assets. In other words, if assets are valued on a market-related approach, a sudden drop in the market value of those assets will result in an immediate reduction in the insurer's solvency position. This is a particular issue where the solvency test is not consistent - if the discount rate used to value the liabilities is not market related and therefore does not reflect the current asset holding. It is also likely that an insurer will place further, more stringent, class-specific solvency requirements on itself. Such requirements are likely to be related to: * The length of tail of the liabilities (ie technical provisions) * The likelihood of catastrophes and accumulations * The spread of risk groups within the portfolio - how well diversified the insurer is by the classes written, and how predictable the liability outgo is. To consider the progress of the insurer on an ongoing basis, allowance must be made for future new business. **Question:** In relation to the bullet points above: (i) State the term commonly used for assets that can be taken into account for the purposes of demonstrating statutory solvency? (ii) Describe what is meant by a ‘custodian’ of assets? (iii) Give an example of a type of asset that an insurer may not be allowed to hold? (iv) Suggest what sort of assets an insurer might be required to hold? (v) Explain why a mismatch reserve might be required? **Solution:** (i) Assets which can be taken into account for the purposes of demonstrating statutory solvency are called **admissible assets**. (ii) The custodian is a party that holds the assets for the insurer and is responsible for the safekeeping of those assets and all administrative matters relating to those assets. (iii) **Derivatives held for speculative purposes**. (iv) An insurer may be required to maintain a **minimum holding in government bonds**. (v) This encourages the insurer to **match closely**, since the more closely it matches the lower the mismatch reserve required. ## The Influence of the Supervisory Authorities on Investment Policy The supervisory authorities may impose some restriction on the assets an insurer can hold and the way in which they are valued. For example, the following controls may be used depending on the level of intervention indicated by the insurer’s breach of requirements: * **Restriction on the amount of certain types of assets** that can be taken into account when assessing solvency * **Custodianship of assets** * **Prevention from holding certain assets** * **Prescription to hold certain assets** * **Requirement to hold reserves against mismatching assets to liabilities or limitations on ability to mismatch**. ## Objectives and Constraints Having a successful investment policy is an integral part of the operation of a general insurance company. The return to shareholders: * **An insurance (or underwriting) result.** * **An investment result:** This includes unrealised capital gains or losses depending on the form of local GAAP. As mentioned earlier, the primary objective with the investment of the assets that support the liabilities of a general insurer is to maximise the return, subject to: * **The overriding constraint of meeting claim and expense liabilities as they fall due.** * **Maintaining a level of solvency compliant with both the statutory regulations and the company's risk appetite.** An insurer would typically analyse its asset risk separately from its insurance risks and other liabilities. The chosen investment strategy must be appropriate for the risk appetite of the general insurer as dictated by the insurer’s management and shareholders. The risk appetite of a general insurer depends on a number of factors or constraints. ### Liabilities Consideration needs to be given to the characteristics of the liabilities in order that appropriate matching assets can be identified. For example, the insurer needs to consider the following characteristics: * **The nature of the existing liabilities –** whether they are fixed or ‘real’ in monetary terms. The majority of general insurance liabilities will be real in nature. * **Currency of existing liabilities –** many domestic, personal and commercial insurers may have portfolios predominantly denominated in their local currency. However, international insurers and reinsurers have portfolios that contain a range of currencies. * **Term of existing liabilities –** most general insurers’ portfolios are likely to contain a significant proportion of short-term liabilities, with a smaller proportion of medium-term and long-term liabilities. * **Level of uncertainty of existing liabilities –** both in amount and timing. * **Estimated future liabilities arising from the portfolio of business planned –** this will depend on the volume and classes of future business written. * **Location of liabilities –** for example, trust funds for Singapore, US, and so on may require assets to be held locally and may restrict profit payments and the assets in which investments are held. * **Whether the liabilities are discounted.** * **Whether the liabilities include expenses.** ### Assets The current asset holding and potential returns on different asset classes must be understood when making the investment decision. **Question:** Explain why it is important to take account of the current asset holding when formulating an investment strategy. **Solution:** This is to ensure that sufficient diversification is achieved and the investment strategy as a whole meets the insurer’s risk appetite. The general insurer should consider the: * **Size of assets, in relation to the current liabilities –** the larger the quantity of free assets, the more the company has freedom to invest widely * **Expected long-term return from various asset classes** * **Expected volatility within the various asset classes** * **Existing asset portfolio** * **Non-investible funds –** not all of the assets will be available for investment, eg moneys held by brokers, policyholders or reinsurers. * **Economic outlook** * **Risk appetite**. ### External Influences The impact of the external environment should be considered when determining the investment strategy, for example: * **Tax treatment of different investments and the tax position of the general insurer** * **Statutory, legal, ethical or voluntary restrictions on how the insurer may invest** **Question:** List statutory restrictions that might impact a general insurer’s investment strategy. **Solution:** * Restrictions on the amount of certain types of assets that can be taken into account when assessing solvency * Custodianship of assets * Prevention from holding certain assets * A prescription to hold certain assets * A requirement to hold mismatching reserves * Statutory valuation requirements * Solvency requirements – most territories have a step-wise process of intervention and therefore the strategy for maintaining solvency is targeted at a much higher level than the pure statutory minimum margin. * Rating agency constraints on capital required to maintain the insurer’s desired rating * Competition – strategy followed by other insurers * Regulatory constraints: for example, those imposed by Lloyd’s, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). ### Insurer-Specific Considerations * **Risk appetite –** each general insurer will differ in the amount of risk it is willing / able to accept, perhaps due to other considerations within the company group, wider management objectives or board appetite. * **Company-specific investment objectives, eg ethical investment**. ## Risks The risks relating to the investment strategy of a general insurer are summarised below: * **Liquidity risk –** the risk of not having sufficient cash to meet the liabilities as they fall due. * **Currency risk –** the risk that the impact from changes in currency exchange rates on the value of the assets or the liabilities in the company’s reporting currency adversely impact the excess of assets over liabilities in that reporting currency. * **Market risk –** the risk relating to changes in the value of the portfolio due to movements in the market value of the assets held. * **Economic risk –** the risk of investing in certain asset classes at certain (disadvantageous) stages in the economic cycle. * **Credit risk –** the risk that a counterparty to an agreement will be unable or unwilling to fulfil its obligations. * **Operational risk –** includes the risk of loss due to fraud or mismanagement of investments within the insurer itself. * **Relative performance risk –** the risk of underperforming comparable institutional investors. * **Group risk –** the risk arising from belonging to a group. The insurer might be required to change investment strategy following a change in the parent’s requirements. * **Contagion risk –** that is, that the collapse of one insurer is more likely to bring down others. **Question:** Explain why cash and short-term bonds are generally less volatile than long-term bonds and equities. **Solution:** We can value an asset using the discounted cashflow approach. A small change in interest rates will have less impact on the cashflows for cash and short-term bonds, since the cashflows are less far in the future. Hence cash and short-term bonds have more stable values. ## Investment Policy in Practice In this section, we consider the different cashflow positions which a general insurer may be in, and the impact on investment strategy. Insurers are usually in one of three situations as regards cashflow: 1. **Insurer expects that premiums and investment income will continue to exceed claim payments for the indefinite future.** 2. **Insurer is in run-off and expects to have to rely on the maturity and realisation of assets.** 3. **Insurer has suffered a major insurance event and needs to obtain short-term liquidity to settle claims.** ### Ongoing Insurer For an ongoing insurer, it is theoretically possible to match the expected claims and expense outgo to the expected premium and investment income by nature (real or fixed), term, amount and currency. In theory, perfect matching can be used to immunise the portfolio from investment losses or profits. Investments can fail for reasons that do not affect liabilities (for instance, if the asset portfolio has a longer mean term than the liabilities, higher interest rates will result in a loss, and vice versa). In practice, it is impossible to match the outgoings of a general insurer perfectly given the uncertainty inherent in the timing and quantum of claims settlement. Even in theory, insurers would not always strive for a perfectly matched portfolio. By taking more risk (moving to a less well matched portfolio) it may be possible to increase returns. If an insurer makes underwriting losses, investment profits (derived from unmatched portfolios) are necessary to offset these losses. It would not be uncommon for long-tail classes to make underwriting losses. However, insurers can still be profitable overall due to good investment returns achieved over the relatively long period between the premium being received and claims paid. The theory of matching does, however, provide the insurer with a basis on which to assess the risks inherent in its investment policy, and in particular, a benchmark against which to measure its exposure to interest rate movements. It will be important for the insurer to understand the matched position even if this is not what is held. By doing so the insurer will understand the degree to which it has moved away from this position and therefore the degree of mismatching risk taken. ### Run-Off Insurer For an insurer in run-off, it is vital that the assets can be liquidated as they are needed, because premium income is insufficient to meet future cashflow needs. If the insurer is not matched, it needs to plan carefully to realise or reinvest assets as needed. **Question:** Suggest what characteristics the insurer would like the assets held to have in this situation. **Solution:** Liquid, in other words close to cash and marketable, ie easy to trade. The assets should also have a high running yield (ie give a high percentage of their return through income that can be used to meet claims, rather than through capital growth). ### Insurer Post Large Event An insurer may suffer a catastrophic event and have many claims to settle at one point in time. In this case, the need is for liquidity to settle claims and many insurers have credit lines available from banks and other financial institutions to assist them with short-term cashflow. Often, large settlements are done with reinsurer support who settles its share of the loss at the same time as the primary insurer, so that the primary insurer is not left having to make a claim on its reinsurer. **Note:** An event can produce losses that lead to a rating downgrade, which could cause severe business difficulties for the insurer due to market concerns. ### New Business When determining its investment policy, an insurer should also consider income from and liabilities associated with policies written after the opening balance sheet date. This is a consideration of whether the company will be in a cashflow positive position given the existence of its projected new business premiums under reasonably plausible scenarios. ## Asset Liability Modelling (ALM) The projections of assets and liabilities become most useful when the relationship between the two is looked at. The model used can be deterministic or stochastic. There is no single, universally accepted method for carrying out such projections, although the simplest approach is to use a deterministic model. Actuaries often refer to such projection models as ALM. ALM is characterised as a simultaneous projection of asset and liability cashflows over a chosen time period. Since this is a cashflow projection, timings and amounts of both asset proceeds and liability outgo need to be understood. One approach is to exclude income on free reserves (the assets in excess of the liabilities) from the asset proceeds calculations and treat the free reserves, and their proceeds, as a balancing item. When ignoring new business and renewals (provided assets are sufficient to meet liabilities), the balance of cash should stay positive at all times. If asset proceeds net of liability outgo are negative at any point, it implies that the assets do not match the liabilities by term. An alternative to a deterministic model is a stochastic model. The latter is, arguably, the more appropriate way of allowing for the volatility and uncertainty underlying the assets and liabilities. ## ALM for Developing an Investment Strategy ### Introduction Historically general insurers have modelled assets and liabilities in 'silos'. Typically, the investment strategy of general insurers is to invest in low-risk, liquid assets because the need to match by term, and holdings of volatile assets would increase the overall uncertainty of the business result. However, the Solvency II regime and the requirement for greater analysis and disclosure by directors means that there is external pressure to better understand all of the risks faced by the company in a holistic fashion. ### What is ALM? ALM is a term used to describe any model that covers both the asset and liabilities of an entity within one structure. This means that an ALM is generally an extension of other models mentioned within these notes, as the basic building blocks of an ALM will be other stochastic or deterministic sub-models, that is, an asset model and a liability model, and the links between the two. The basic concept is quite simple: * Project liability outgo in each future time period * Project asset proceeds in each future period * Compare the two for each future period * Run the comparisons again using different assumptions * Decide whether the asset proceeds are appropriate for the liability outgo * If not, investigate alternative asset distributions. Inevitably, the reality is much more complex. ### The ALM Process As described above, ALM is a catch-all term that could encompass models of very different complexity, varying from simple deterministic scenario-testing frameworks to complex stochastic models. An ALM may be used to determine the optimal investment strategy in line with the firm’s investment goals (eg maximise profitability for a chosen risk appetite). If the purpose is to investigate the suitability of the asset distribution compared to our present liabilities, then the projections might be made without any allowance for future new business. However, if the purpose is to investigate the overall financial position of the office and consider its future solvency position, then the projection will need to incorporate future business into our projections. The projections will be carried out on a best estimate basis considering the overall liability outgo and asset proceeds in each future time period. For insurers with several million policyholders it will be more efficient to carry out the projections using model points. Each model point is representative of a set of policyholders and the modelled experience can then be scaled up to reflect the total size of the portfolio. The advantage of this approach is that a much smaller volume of data is required, and the model will be much more manageable. As we saw in Section 4, the liability outgo will consist of: * Total gross claim payments * Reinsurance and other recoveries * Expenses * Outstanding premiums received * Tax and dividend payments The claim payments are almost always the most significant item of the liability outgo and will be subject to the most uncertainty. An ALM may also be used to determine solvency capital or in a wider capital management programme. If the solvency test is based on market values then the solvency position will be directly influenced by the volatility of the capital values of assets. The choice of asset mix will therefore be crucial to ensuring the ongoing capital adequacy of the company. If a projection model is required to incorporate an assessment of the likely level of solvency at each period in the future, then it must be extended to allow for any statutory requirements relating to the valuation of asset and liabilities. ### The Typical Structure of an ALM * **Inputs - Assumptions** * Target asset portfolio * Investment rules / guidelines * A starting assumption might be the current asset portfolio * Economic scenarios * Liabilities * Inputs for stochastic modelling of Gl liabilities covered elsewhere in the Core Reading * **Modelled Variables & Interdependencies** * This will depend on the scope of the model. In general terms: * Assets within asset portfolio * Liabilities within liability portfolio * Inflationary links * Interdependencies between correlated variables * **Outputs** * Output is the collection of results for each modelled output variable. * This information will be summarised to derive information of interest. * Enables analysis of optimal strategies by comparing various statistics of the outputs for various different input strategies. * Projection of expected outcomes for business planning purposes. * **An ESG** will typically take the form of a specialised asset model that stochastically models the performance and interactions of various asset classes. The output of this model will be the performance for each economic variable (for example, inflation / asset classes) at each future projection point, for several simulations. This table of simulation outputs will then be used within the main ALM as if the ESG was a part of the ALM. The reason for separating the two models is that an ESG can be a very complex model, the building, parameterisation and running of which is often outsourced. * **An economic scenario generator (ESG)* is a stochastic asset modelling tool.** The ESG produces interest rates and inflation rates, and translates those into the level of the market and asset prices for each model point. The insurer will select the strategy that best meets the investment objectives, that is, maximising the return subject to the overriding constraint of meeting claim and expense liabilities as they fall due and maintaining an appropriate level of solvency. In theory, it would be possible to assess liquidity risk associated with a particular investment strategy using Dynamic Financial Analysis (DFA). **However, it should be noted that many practitioners use the terms DFA and ALM interchangeably.** ### Use of Stress and Scenario Testing Stress testing involves exposing the chosen strategy to extreme events to check it is robust, ie to check that the resulting solvency position remains within the risk guidelines of the company. Scenario testing involves developing consistent sets of assumptions that can be used to investigate various situations, for example downgrading of assets, a low or high inflation environment, etc. ### Reverse Stress and Scenario Testing A complementary case of stress and scenario testing is reverse stress testing. Some regulatory authorities require firms to carry out reverse stress testing. Reverse stress testing differs from general stress and scenario testing in that the starting point is the assumed outcome of business failure, thus the exercise being the identification of circumstances where this might occur, whilst the latter looks at the resulting outcomes arising from specified changes in circumstances. In other words, a reverse stress and scenario test identifies the circumstances / model assumptions required for the business to fail. ## Asset Liability Modelling Case Study The purpose of this case study is to develop your understanding of how the material in this chapter might be applied to a particular practical problem. **Instructions:** To get maximum benefit from it you should attempt the question fully yourself before checking your attempt against our solution. ### Case Study You are the actuary to a medium-sized proprietary private motor insurer. Your insurance company currently protects the account with an individual risk excess of loss reinsurance contract. The current arrangements have been in place for the past ten years. You have been asked to review the level of the lower retention limit of the treaty. To do so, you decide to conduct some stochastic asset liability modelling to investigate the effect that different levels of retention are likely to have upon future profitability and financial strength. **Question:** (i) Describe how you would estimate the future liability outgo. (ii) Describe how you would investigate the choice of an appropriate retention level given that the company wants to maximise its