ALM is universally defined as a comprehensive analysis of the asset portfolio in light of current liabilities and future cash flows of a going-concern company, incorporating existing asset and liability portfolios as well as future premium flows. ALM also considers additional risk factors beyond interest rate changes such as inflation, credit, and market risk. ALM also considers actions beyond the characteristics of a fixed income portfolio and seeks to identify and exploit hedges.
Insurance companies can benefit from a more integrated analysis of the asset and liability portfolios in seeking better risk-return decisions. An enterprise-wide analysis of potential risks and rewards affords an opportunity to analyse the company’s investment portfolio and underwriting portfolio. Since insurance liabilities are far less liquid than assets, such analysis and management activity tend to focus on adjustments to the investment portfolio, given the constraints of the reserves and underwriting portfolio, to improve the risk-return characteristics. In this respect assets can be thought of as a way to hedge liability risk. However, management activity need not be confined to fine-tuning investment strategy. Future underwriting considerations, along with other hedges such as reinsurance, are risk-management variables at their disposal.
Venter et al. presented a series of simple examples illustrating that the optimal risk-return portfolio decisions are very different as the asset and liability considerations become more realistic and complex. The authors started with a standalone asset portfolio, then with adjustments added a constant fixed duration liability, a liability that varied as to time and amount, and then added consideration of cash flows from current underwriting. As the various layers of complexity are added to the illustration, the nature of the inherent risks changes, as does the optimal investment portfolio.
The study did not address tax considerations, which can have a profound impact on investment decisions. Recent studies have found that insurers consider cyclical changes in the portfolio between tax-exempt and taxable fixed income securities over the course of the underwriting cycle to be one of the principle drivers in investment strategy. In addition to the integration of underwriting and investment results, such strategies rely on reallocation of assets to maximise income while avoiding alternative minimum taxes (AMT).
Consideration of equities, too, adds complexity and richness to the asset–liability analysis. Equities are considered risky in their own right and will imply a potentially worse downside risk to capital. Some believe that equities may provide a better inflation hedge for liabilities in an increasing loss cost environment. This proposition may be tested through the enterprise risk model, although the conclusion will be sensitive to input assumptions of the incorporated macroeconomic model.
In 2002, the Casualty Actuarial Society Valuation, Finance, and Investment Committee (VFIC) published a report testing the optimality of duration matching investment strategies for insurance companies. VFIC attempted to tackle Venter’s most complex scenario discussed above.
Where Venter et al., focused on changes in GAAP pretax surplus changes as the risk measure, VFIC looked at several different risk measures on both a statutory and a GAAP basis. Return, too, was considered on both accounting bases. In doing so, VFIC’s conclusion as to optimality was what one might expect in the real world: it depends. Duration matching was among a family of optimal strategies, but the choice of specific investment strategies was dependent on the company’s choice of risk metrics, return metrics, and risk-return tolerances or preferences.
An asset–liability modelling approach
It has been asserted that an enterprise-wide model is the ideal way to model and ultimately manage an insurance company investment portfolio. ALM makes for an excellent application of such an integrated model.
1.Start with models of asset classes, existing liabilities, and current business operations.
2.Define risk metrics for the analysis.
3.Similarly, management must define what constitutes return.
4.Consideration must be given to the time horizon of the analysis and the relevant metrics.
5.The model will have to consider relevant constraints.
6.The model should be run for a variety of investment strategies, underwriting strategies, and reinsurance options under consideration.
7.An efficient frontier – a plot of the return metric versus the risk metric – can be constructed across the various portfolio scenarios.
8.Since liabilities are more illiquid, the asset–liability analysis and management can be largely asset centric given the existing liabilities.
9.Having selected a targeted point on an efficient frontier and a companion reinsurance strategy, simulation output should be analysed to identify those scenarios where even the preferred portfolio(s) performed poorly.
Future research
While enterprise modelling is perhaps the only way to adequately address asset–liability management issues, there are a number of real-world issues that are subject of continuing research. Correlations can materially alter the risk of the optimal portfolio. Also, models of unpaid losses have not been developed as explanatory models. That is, unlike asset models, reserving models do not predict future loss payments with parameters linking losses to economic indices. Inflation sensitivity is often hypothesised on an accident year, a calendar year, or a payment year basis, but rarely explicitly developed from historic economic data and projected on the basis of, say, an economic scenario generator.
This article is an edited version of an entry in the “Encyclopedia of Quantitative Risk Analysis and Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by permission.
