Society of Actuaries Professional Actuarial Specialty Guide Asset-Liability Management 2002-2003 SOA Asset-Liability Management Specialty Guide Task Force Members: Warren R. Luckner, FSA, Chairperson Mark C. Abbott* James E. Backus, FSA, MAAA Sergio Benedetti, FSA, FCIA, MAAA Dan Bergman* Samuel H. Cox, FSA, MAAA Sholom Feldblum, FSA, FCAS, MAAA Charles L. Gilbert, FSA, FCIA Xisuo Louis Liu, ASA, MAAA Vincent Y. Lui, ASA, EA, MAAA, MSPA Jeffrey A. Mohrenweiser, FSA, MAAA William H. Overgard* Hal Warren Pedersen, ASA Max J. Rudolph, FSA, MAAA Elias S. Shiu, ASA Peter L. Smith, Jr., FSA, MAAA *Other ALM professionals SOA Staff: Clay Baznik, director of publications; Maryellen Beach, senior project manager; Glenda Greenberg, associate editor; Valentina Isakina, ASA, MAAA, staff actuary; Julie Young, practice area administrator Copyright ©2003 Society of Actuaries S OA Professional Actuarial Specialty Guide: Asset-Liability Management Table of Contents Asset-Liability Management.................................................................1 INTRODUCTION......................................................................................................................1 WHAT IS ALM?.....................................................................................................................2 THE ROLE OF THE ACTUARY.................................................................................................3 THE ROLE OF SCIENTIFIC PRINCIPLES AND ACTUARIAL STANDARDS OF PRACTICE............3 RELEVANT PROFESSIONAL ORGANIZATIONS........................................................................4 FORMAT OF THE GUIDE'S CONTENT......................................................................................5 REFERENCES...........................................................................................................................5 Basics in Financial Economics Relevant to ALM...........................9 INTRODUCTION......................................................................................................................9 References—Introduction..................................................................................................9 OVERVIEW OF FINANCIAL MARKETS..................................................................................10 Reference—Overview of Financial Markets...................................................................10 RISK/RETURN TRADEOFF MODELS......................................................................................10 References—Risk/Return Tradeoff Models.....................................................................11 BEGINNING DERIVATIVES....................................................................................................11 References—Beginning Derivatives...............................................................................12 THE EFFICIENT FRONTIER AND ASSET ALLOCATION..........................................................13 References—General.......................................................................................................14 References—Property/Casualty......................................................................................15 References—Pensions......................................................................................................15 BEHAVIORAL FINANCE........................................................................................................16 References—Behavioral Finance.....................................................................................16 Tools and Techniques............................................................................18 BASIC RISK MANAGEMENT METRICS..................................................................................18 General Introduction of Duration and Convexity..........................................................18 General Definition...........................................................................................................18 Variations of the General Definition of Duration...........................................................19 Macaulay Duration.........................................................................................................20 Modified Duration..........................................................................................................20 Effective Duration...........................................................................................................21 Other Related Concepts...................................................................................................22 Definition of Key Rate Duration or Partial Duration....................................................22 Applications of Duration................................................................................................24 i S OA Professional Actuarial Specialty Guide: Asset-Liability Management Weaknesses of Duration as a Risk Measure....................................................................24 References—Fixed and Certain Cash Flows...................................................................25 References—Interest-sensitive Cash Flows.....................................................................26 References—Hedging with Swaps, Futures and Options...............................................28 References—Multivariate Models...................................................................................29 IMMUNIZATION AND DEDICATION.....................................................................................29 References—Fixed and Certain Cash Flows...................................................................30 References—Interest-sensitive Cash Flows.....................................................................31 References—Hedging with Swaps, Futures and Options...............................................32 References—Multivariate Models...................................................................................33 ADVANCED RISK MANAGEMENT METRICS........................................................................33 References—Advanced Risk Management Metrics........................................................35 FINANCIAL MARKET MODELING........................................................................................36 Arbitrage-Free Interest Rate Models...............................................................................38 Interest Rate Modeling with Default Risk......................................................................41 Equity Models.................................................................................................................41 Data Issues......................................................................................................................42 Role of Inflation...............................................................................................................43 Practical Problems...........................................................................................................43 Discrete-Time vs. Continuous-Time Models..................................................................44 Interpretation of Financial Market Models.....................................................................44 Reference—Interpretation of Financial Market Models.................................................45 References—Discrete-Time Term-Structure Models......................................................45 References—Survey of Continuous-Time Term-Structure Models................................46 References—Books...........................................................................................................46 DERIVATIVES.......................................................................................................................49 General Functionality.....................................................................................................49 Derivatives Pricing.........................................................................................................51 Derivatives Application in ALM....................................................................................51 References—General Functionality................................................................................52 References—Derivatives Pricing....................................................................................53 Recommended Journals...................................................................................................54 Credit Derivatives—Credit Default Swap......................................................................55 Other New Corporate Bond Products.............................................................................56 References........................................................................................................................57 Selected Web Sites Regarding Research on Credit Risk Analysis..................................58 FAIR VALUE OF LIABILITIES.................................................................................................58 Background......................................................................................................................58 References—Fair Value of Liabilities, Background.........................................................59 Insurance Liabilities........................................................................................................59 References—Draft Accounting Standards......................................................................61 ii S OA Professional Actuarial Specialty Guide: Asset-Liability Management References—Actuarial Task Force Reports.....................................................................61 References—Theoretical Readings and Examples...........................................................62 References—Other Readings...........................................................................................65 Pension Liabilities...........................................................................................................66 References—Pension Liabilities......................................................................................67 PERFORMANCE MEASUREMENT AND BENCHMARKING.....................................................68 Portfolio Manager Evaluation.........................................................................................70 Investment Income Allocation........................................................................................71 Reference—General.........................................................................................................73 References—Portfolio Manager Evaluation....................................................................73 References—Investment Income Allocation...................................................................73 Applications of ALM.............................................................................74 CORPORATE ALM...............................................................................................................74 References........................................................................................................................75 ALM IN PRODUCT DEVELOPMENT.....................................................................................78 References—General.......................................................................................................78 References—Annuities....................................................................................................79 References—Equity-Indexed Annuities..........................................................................81 References—Group..........................................................................................................81 References—Single Premium Deferred Annuities..........................................................81 References—Variable Annuities.....................................................................................82 References—Life, Equity-Indexed...................................................................................82 References—Retirement Plans........................................................................................82 PROPERTY AND CASUALTY INSURANCE..............................................................................83 Early Studies...................................................................................................................83 Term Structure of Interest Rates....................................................................................84 Common Stock Durations...............................................................................................84 Dynamic Financial Analysis (DFA)...............................................................................84 Expected Policyholder Deficit.........................................................................................85 Coherent Risk Measures..................................................................................................86 Risk-Based Capital Requirements...................................................................................86 Federal Income Taxes......................................................................................................86 Asset-Liability Efficient Frontier....................................................................................86 References........................................................................................................................87 PENSION PLAN ALM..........................................................................................................93 References—Pension Plan ALM.....................................................................................94 iii S OA Professional Actuarial Specialty Guide: Asset-Liability Management ACCOUNTING AND REGULATORY ISSUES APPLICABLE TO ALM.......................................95 FAS 133...........................................................................................................................95 AICPA Standards...........................................................................................................95 U.S. Insurance Statutory Issues.....................................................................................96 International Accounting Standards..............................................................................96 American Academy of Actuaries (AAA)........................................................................96 Actuarial Standards Board (ASB)..................................................................................96 European Union (EU).....................................................................................................96 Enterprise Risk Management Commentary..................................97 References........................................................................................................................98 Appendix...................................................................................................99 iv S OA Professional Actuarial Specialty Guide: Asset-Liability Management Copyright ©2003 Society of Actuaries Asset-Liability Management Introduction This specialty guide is a background reading list reference for the practice of asset-liability management (ALM). It is intended to provide guidance to anyone seeking to gain knowledge regarding ALM, especially with respect to its application to financial security systems such as life or health insurance, property and casualty insurance and pensions. Some sections have property/casualty-specific and pension- specific references shown separately, and special sections are devoted to property/casualty-specific references and to pension-specific references. We hope that this guide also will be useful to an audience beyond the actuarial profession seeking to understand a challenging but increasingly important subject. The guide should be viewed as a preliminary road map for any practitioner seeking direction to enhance his or her knowledge of ALM. No particular level of expertise is assumed, although a basic understanding of the investments available to a financial institution is helpful. To make the guide as widely useful as possible, we have attempted to indicate the level of difficulty of each reference (basic, intermediate, advanced). Recently, there has been much discussion regarding the concept of enterprise risk management (ERM). ERM is a broader concept than ALM. ERM can be viewed as a comprehensive and integrated process of identifying, assessing, monitoring and managing the risk exposure of an organization, ideally through a formal organizational structure and a quantitative approach. The goal of ERM is to minimize the effects of risk on an organization's capital and earnings, and to better allocate its risk capital. Thus, ERM considers the broad range of risks associated with operating a business, including financial, strategic, operational and hazard risks. Because financial institutions thrive on the business of risk, they are good examples of companies that can benefit from effective ERM. ALM is a significant component of ERM because it is an important process in addressing financial risk. This guide is primarily concerned with ALM, but includes a short section on ERM. For additional information regarding ERM, see the Society of Actuaries (SOA) Risk Management Task Force Web site (www.soa.org/sections/rmtf/rmtf.html). The work of the task force also involves a review of other risk management issues including economic capital calculation and allocation, equity modeling, extreme value models, health risk management, policyholder behavior in the tail, pricing for risk, risk-based capital covariance, risk management future and strategy, and risk management metrics. ALM Specialty Guide 2003 1 S OA Professional Actuarial Specialty Guide: Asset-Liability Management What Is ALM? ALM is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. ALM can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve an organization's financial objectives, given the organization's risk tolerances and other constraints. ALM is relevant to, and critical for, the sound management of the finances of any organization that invests to meet its future cash flow needs and capital requirements. Traditionally, ALM has focused primarily on the risks associated with changes in interest rates. Currently, ALM considers a much broader range of risks including equity risk, liquidity risk, legal risk, currency risk and sovereign or country risk. ALM is practiced in diverse settings: • Derivative dealers manage their long and short positions. • Bankers coordinate the repricing horizons of their assets and liabilities. • Pension plans adjust their investments to mirror the characteristics of their liabilities with respect to interest rates, equity returns and expected changes in wages. • Insurers select investment strategies to ensure they can support competitive pricing and interest crediting strategies. While each of these involves the application of ALM techniques to a particular financial problem, the implementations in these situations may bear little resemblance to each other. The derivative dealer must make many decisions during the course of a trading day, and is therefore likely to use a technique such as Value at Risk (VAR) based on intra-day market price volatility that can be used quickly and easily. Simulation modeling of those risks is a luxury not available due to time constraints. On the other hand, insurers typically manage ALM risks using simulation models that may take weeks or months to operate and validate. Daily application of risk limits is neither feasible nor necessary. Similarly, bankers' ALM risks are primarily those that will show up in profits in the near- to medium-term future, so their approach to ALM may emphasize short-term income and expenses, while a pension plan, taking a longer view, may focus on the present value of required contributions. ALM Specialty Guide 2003 2 S OA Professional Actuarial Specialty Guide: Asset-Liability Management These are all valid applications for ALM, but the appropriate tools and measurements for each situation can differ significantly. The choice of appropriate tools and measurements depends in turn on identifying the primary risk of concern. For example, in a pension fund, risks include levels of contributions, expenses, or net income, and balance sheet items. Minimizing risk in any of these areas may increase risk to others. Senior management of a financial organization often needs help in focusing on the primary risk. The readings listed in this introductory section are intended to provide a basic overview of most topics and concepts in ALM. The sections that follow survey the broad range of ALM tools and applications that exist today. The approach to ALM in a particular situation must be chosen with regard to available time, human resources, capital, information and management philosophy. The Role of the Actuary Actuaries measure, model and manage risk. Risk associated with the ALM process is one of the most important risks faced by many financial security systems. The current professional actuarial education and qualification process provides actuaries knowledge and understanding of assets and liabilities and how they are interrelated. This knowledge includes an understanding of the operation of financial markets, the instruments available and the use of synthetic instruments. Financial reporting and product development actuaries are expected to understand the relationship of the company's assets to its liabilities so as to reflect the risks inherent in the business and thereby enhance its profitability and solvency. Insurance and investment products are continually being redesigned, updated, expanded and replaced. The practicing actuary considers these changes and how they affect the company. The actuary must be able to communicate such changes to the company's portfolio managers (or be part of such portfolio management). The coordination of product development, investment operations and financial reporting is essential for a successful financial security system. Actuaries are well prepared through education and experience to perform this role. The Role of Scientific Principles and Actuarial Standards of Practice Actuarial standards of practice provide guidance to actuaries as they fulfill their various responsibilities in order to ensure that their employers, clients and the public interest are well served. As described by the Actuarial Standards Board (ASB) in the United States: "Standards of practice serve to assure the public that actuaries are professionally accountable. At the same time, standards provide practicing actuaries with a basis for assuring that their work will conform to generally accepted ALM Specialty Guide 2003 3 S OA Professional Actuarial Specialty Guide: Asset-Liability Management principles and practices." Thus, actuarial standards of practice are an important reference for ALM work, as well as any other actuarial task. Actuarial standards of practice are established by the ASB in the United States and by the Canadian Institute of Actuaries (CIA) in Canada. The standards that have been established, or are in the process of being established (exposure drafts or discussion drafts), by the ASB can be viewed by accessing the ASB Web site at www.actuarialstandardsboard.org. The standards established, or in the process of being established, by the CIA can be viewed by accessing the CIA Web site at www.actuaries.ca and clicking on "Publications" and then selecting "Blue Book (Standards)." To assist the ASB and the CIA in developing standards of practice, the SOA has formed a number of committees and task forces to articulate an intellectual and scientific basis for such standards. The SOA Task Force on Asset/Liability Management Principles is in the process of articulating that basis for ALM. The goal is to have a final draft of a principles document completed during 2003. The first publication of the document may be an exposure draft. Relevant Professional Organizations There are a number of organizations that provide information that might be of value to those interested in learning about ALM. For your information and convenience the following table lists a few of the key organizations and their Web addresses. Organization Web Address American Academy of Actuaries (AAA) www.actuary.org Canadian Institute of Actuaries (CIA) www.actuaries.ca Casualty Actuarial Society (CAS) www.casact.org Society of Actuaries (SOA) www.soa.org Association for Investment Management and www.aimr.org Research (AIMR) Global Association of Risk Professionals (GARP) www.garp.com Professional Risk Managers' International www.prmia.org Association (PRMIA) ALM Specialty Guide 2003 4 S OA Professional Actuarial Specialty Guide: Asset-Liability Management Format of the Guide's Content Each section of the guide includes commentary introducing the topic of the section and related issues. For most references, the guide identifies the reference's level of difficulty. The guide also identifies references that have been part of the syllabus for SOA or CFA examinations. The appendix lists alphabetically, by author (or source if, for example, the reference is a compilation of papers presented at a conference or seminar), all the references included in the guide, and the section(s) in which they are referenced. The appendix is intended to provide users of the guide an opportunity to navigate through the guide based on reference(s) of interest, to identify all the sections in which a particular reference appears or to determine the scope of the references. We welcome your suggestions for changes or additional references. Please direct your comments to Julie Young at the SOA office ([email protected]). References Reference Level of Difficulty Comments Bodie, Z., A. Kane, and A. Marcus. 2002. Basic Has been part of the SOA exam Investments. 5th ed. New York: Irwin syllabus. McGraw Hill. Canadian Institute of Actuaries ALM Focus is life insurance. The Practitioners Association. group discusses practice-related and emerging issues as part of an ongoing process to exchange knowledge and develop ALM best practices. Canadian Institute of Actuaries Working Formed to further education and Group on ALM. research in ALM and to promote best practices. The focus of the group is life insurance. Forbes, S., M. Hays, S. Reddy, and K. Basic Stewart. 1993. Asset-Liability Management in the Life Insurance Industry. Atlanta, GA: Life Office Management Association, Inc. Ingram, D., and L. Zacheis. 1994. "Asset- Basic Has been part of the SOA exam Liability Matching," Chapter 22 in Life syllabus. Insurance Accounting. 3rd ed. IASA. ALM Specialty Guide 2003 5