Asset Liability Management

Transcription

1 December 4, 2008 Asset Liability Management performance metrics and risk attribution Charles Gilbert, FSA, FCIA, CFA, CERA

2 Asset Liability Management Performance metrics and risk attribution Review of traditional approach Developments in the risk management landscape Integrating ALM with Enterprise Risk Management Performance metrics and risk attribution 2

3 Leveraged liability cash flow profile Liability Cash Flow Profile In force Asset Cash Flow Profile

4 Traditional risk metrics Multiple dimensions of risk need to be measured

5 Probability weighted measures Particularly useful in performing risk optimization Static exposure at risk measure provide limited information > Duration/convexity are based on simple premises and may give false sense of comfort > Partial duration need to be supplement with covariance structure Probability weighted measures prone to RAROC calculations > Allows quantification of yield curve bets within a principled risk framework > Multi factor interest rate model or Principal Component Analysis (PCA) Objectives of PCA > Reduce the number of explanatory variables > Find hidden patterns in data and simplify interpretation 5

6 Traditional approach still prevalent Asset management executed separately Focus of asset management is on assets > maximize total return > maximize book yield > simple ALM risk metrics Investment (i.e. asset-only) objectives specified by insurance company / client Assets managed and performance measured against benchmark > asset-only benchmark > liability-driven benchmark Attribution performed against benchmark > active asset management decisions not explicitly measured 6

7 Traditional performance metrics Focus on benchmark and related attribution analysis No risk attribution corresponding to performance ALM risk metrics focus on interest rate risk > Level of mismatch Duration mismatch: D A D L Partial Duration, Effective Duration, Dollar Duration Convexity exposure: C A C L > CALM prescribed interest rate risk provision > Deterministic Scenario Testing > Regulatory Capital C3 > Stochastic Modeling / Risk Profile > Economic Capital No mention of financial objectives or performance 7

8 Shortcomings undermine performance Financial objectives are not being achieved Fundamental flaw: Beating benchmark and/or achieving investment objectives does not necessarily mean financial objectives will be met No separation of sources of value-added from ALM and active asset management decisions Capital and risk-adjusted performance cannot be properly factored in > cannot evaluate whether fairly compensated for risks taken 8

9 Performance measures lack transparency Not clear where value-added comes from Active asset management bets not explicitly disclosed ex ante nor measured ex post Unintended, implicit bets not recognized Result may reward a poorly matched position > E.g. interest rate exposure not from a deliberate view on rates 9

10 Conflicts between ALM and Asset Management Resistance to moving away from traditional approach Benchmark may be inappropriate > benchmark and or targets frequently oversimplified for benefit of asset manager Entire process may cater more to needs of asset manager, not client > asset manager requires specification of investment objectives, not financial objectives > asset manager requires benchmark and targets that may bear little resemblance to actual liabilities > value-added ALM strategies may disrupt performance measurement of asset manager Traditional asset management divorces assets from liabilities for benefit of asset manager 10

11 Developments in risk management Companies starting to execute ALM at strategic level Rating Agencies and Regulators evaluating quality of risk management Recent losses and failures drawing greater attention to effectiveness of risk management Greater recognition of value of executing ERM as a strategic decision-making framework 11

12 Most companies run ALM at a tactical level Strategic ALM is not necessarily about eliminating risk 12

13 Integrating ALM with ERM ALM conceptual framework consistent with ERM Replace traditional benchmarks with actual liabilities Replace focus on narrow investment objectives with focus on overall financial objectives Change process so that ALM drives investment decisions 13

14 ALM Conceptual Framework Needed in order to execute ALM at strategic level 14

15 ERM defines how performance measured Performance metrics based on financial objectives Performance metrics based on financial objectives > maximize accounting earnings (CGAAP, future earnings) > maximize embedded value (EEV, MCEV) > maximize economic surplus > maximize investment income / total return > minimize economic capital > minimize required regulatory capital ALM attribution analysis focuses on change in performance metric over the period > quantifies impact on performance metric for each source of risk > most companies focus on change in interest rates for ALM 15

16 ALM attribution analysis Creates awareness of impact of financial variables US Treasury Yield Curve Economic Surplus BOP 111,673 Change due to Yield Curve 2,292 Change due to Liabilities (19,982) Change due to Assets 26,718 Total Change 9,028 Economic Surplus EOP 120,701 Change due to Assets 26,718 New Business 14,399 Asset trades 2,244 Change due to aging of cash flows 10,075 Change due to assumptions changes - Change due to Liabilities (19,982) New Business (12,413) Change due to aging of cash flows (7,569) Change due to assumptions changes - 16

17 ALM attribution analysis Recognizes sources of value added Identify value from both ALM and active management > ALM strategies (excluding tactical credit views, security selection, rate anticipation, etc) Active asset management can adds value on top of ALM optimized portfolio > Any bets (i.e., active positions) are recorded ex ante and measured ex post thus fully transparent > Measure actual value added from active management, not just value against a benchmark Attribution not restricted to a particular measurement basis > could be change in ES, accounting results or other financial objective(s) Impact of passive position / prior period decisions / noise 17

18 Quantifying sources of value added Incremental value added from active asset management ALM attribution analysis is a valuable tool to separate the value added from ALM and asset management ALM strategies are on a default-free basis Active asset management can add further value by taking bets within risk limits Impact of ALM Strategies Change in ES Before Rebalance (5,045) Change in ES After Rebalance 9,028 Total 14,073 Impact of Active Asset Management Change in ES due to rate anticipation 1,213 Change in ES due to credit selection 750 Total 1,963 18

19 How well do risk metrics predict impact? Simplifying assumptions wrt interest rate risk can be way off US Treasury Yield Curve Change due to Yield Curve 2,292 Change predicted by Duration (190) Contribution predicted by Convexity (205) Change predicted by -D( i)+.5c ( i) 2 (395) Change predicted by Partial Duration 2,606 Change predicted by Effective Duration (1,700) Change predicted by Effective Convexity (1,026) Change predicted by -D( i)+.5c ( i) 2 (2,726) Limitations of simple risk metrics > can be poor predictors of actual risk > if limitations not understood or naively applied can lead to unexpected results 19

20 Attribution gives greater insight Valuable tool to manage assets and liabilities Impact on financial objectives broken down by source Bets are made explicit > duration or rate anticipation > credit selection > backing fixed income liabilities with non-fixed income assets Value added by asset manager is transparent Performance measurement is more meaningful but difficult to implement in practice Some companies feel that performance measurement of asset management is less important than successful execution of ALM 20

21 Thank You! Contact info: Charles L. Gilbert, FSA, FCIA, CFA, CERA Nexus Risk Management charles.gilbert@nexusrisk.com 21