ASSET MANAGEMENT ALM FRAMEWORK

Transcription

1 ASSET MANAGEMENT within an ALM FRAMEWORK LE MÉRIDIEN SINGAPORE SEPTEMBER 6 7, 2007 Charles L. Gilbert, FSA, FCIA, CFA

2 Traditional Asset Management Focus on asset returns Assets managed against benchmark Asset-only benchmark Liability-driven benchmark Investment (i.e. asset-only) objectives specified by client Beating benchmark and/or achieving investment objectives does not necessarily mean financial objectives will be met 1

3 Pension liabilities: long-term and uncertain cash flows - Pension Plan Liability Cash Flows (10,000) (20,000) (30,000) (40,000) (50,000) (60,000) (70,000) (80,000) Duration = 15.4 years 2

4 Two approaches to managing pension assets Asset Only Asset Liability Traditional Approach to Pension Investment Focus on asset only return / pure asset performance Does not capture risk exposure Asset mix determined using efficient frontier Liability-Driven Investment ( LDI ) Approaches Maximize risk-return trade-off to liabilities Risk relative to liabilities more clearly defined Risk to solvency ratios reduced 3

5 Traditional approach applied to pensions Strategic asset allocation and selection of benchmark are the major sources of returns and risk value added by asset manager against benchmark is lower order of magnitude Investment strategy loosely recognizes risks associated with pension liabilities investment objective is to maximize expected return for a given amount of risk equities viewed as a good hedge against inflation, expected to outperform bonds in the long term 4

6 SAA determined using efficient frontier analysis Minimize risk for a given level of expected return Maximize expected return for a given level of risk Based on expected return, standard deviation and correlation between asset classes E[R] σ 5

7 Benchmarks selected to manage assets Good asset manager can add value vs. benchmark: Credit quality assessment capabilities based on fundamental analysis Tactical asset allocation Interest rate anticipation strategies Other yield enhancement strategies 6

8 Asset-only benchmarks Traditional approach for pensions uses asset-only benchmark Benchmarks include market indices Lehman Aggregate S&P500 peer performance quartile performance May include duration target Focus is on total return of assets irrespective of performance of liabilities 7

9 Asset-Only Benchmark Example: No change in interest rates Benchmark Weight Index Actual Asset Manager Outperformance S&P500 60% 10% 11% 1% Lehman Aggregate (5 yr duration) 40% 5% 6% 1% Portfolio 100% 8% 9% 1% Liabilities (15 yr duration) 6% Solvency Ratio 103% 8

10 Asset-Only Benchmark Example: Interest rates flatten long term rates down 1% Benchmark Weight Index Actual Asset Manager Outperformance S&P500 60% 10% 11% 1% Lehman Aggregate (5 yr duration) 40% 5% 6% 1% Portfolio 100% 8% 9% 1% Liabilities (15 yr duration) 21% Solvency Ratio 90% 9

11 The perfect storm Asset-only approach exposed pension plans to significant risk Solvency deficits resulted from falling interest rates and stock prices (so-called Perfect Storm ) 140% 130% 120% 110% 100% 90% 80% Funding Ratio - S&P 500 Pension Plans 70% 60% Source: Credit Suisse 10

12 Liability-Driven Investment framework Pension crisis could have been avoided Asset-only approach focused on achieving high asset returns irrespective of liabilities Asset-Liability approach focuses on achieving asset returns that match returns of liabilities 1) increase in asset value greater than increase in liabilities and/or 2) decrease in asset value less than decrease in liabilities 11

13 Liability-Driven Benchmark Example: No change in interest rates Benchmark Weight Index Actual Asset Manager Outperformance S&P500 0% 10% N/A N/A Replicating Portfolio (15 years) 100% 6% 7% 1% Portfolio 100% 6% 7% 1% Liabilities (15 yr duration) 6% Solvency Ratio 101% 12

14 Liability-Driven Benchmark Example: Interest rates flatten long term rates down 1% Benchmark Weight Index Actual Asset Manager Outperformance S&P500 0% 10% N/A N/A Replicating Portfolio (15 years) 100% 21% 22% 1% Portfolio 100% 21% 22% 1% Liabilities (15 yr duration) 21% Solvency Ratio 101% 13

15 Liability-Driven Benchmark plus Beta Example: No change in interest rates / equities +10% Benchmark Weight Index Actual Asset Manager Outperformance S&P500 50% 10% 11% 1% Duration 30 yr Pooled Fund 50% 6% 7% 1% Portfolio 100% 8% 9% 1% Liabilities (15 yr duration) 6% Solvency Ratio 103% 14

16 Liability-Driven Benchmark plus Beta Example: Interest rates flatten / equities +10% Benchmark Weight Index Actual Asset Manager Outperformance S&P500 50% 10% 11% 1% Duration 30 yr Pooled Fund 50% 36% 37% 1% Portfolio 100% 23% 24% 1% Liabilities (15 yr duration) 21% Solvency Ratio 102% 15

17 Liability-Driven Benchmark plus Beta Example: No change in interest rates / equities 10% Benchmark Weight Index Actual Asset Manager Outperformance S&P500 50% -10% -9% 1% Duration 30 yr Pooled Fund 50% 6% 7% 1% Portfolio 100% -2% -1% 1% Liabilities (15 yr duration) 6% Solvency Ratio 93% 16

18 Liability-Driven Benchmark plus Beta Example: Interest rates flatten / equities 10% Benchmark Weight Index Actual Asset Manager Outperformance S&P500 50% -10% -9% 1% Duration 30 yr Pooled Fund 50% 36% 37% 1% Portfolio 100% 13% 14% 1% Liabilities (15 yr duration) 21% Solvency Ratio 94% 17

19 New developments focus on Liability-Driven approach Greater focus on ALM due to financial losses Global shift to marking-to-market of assets and liabilities Regulatory pressure to accelerate funding of deficits New instruments enabling effective risk management Move towards Principles-Based Approaches 18

20 Interest risk remains significant challenge for insurers 60,000 Liability Cash Flows 40,000 20,000 pre-funding problem - (20,000) (40,000) (60,000) substantial reinvestment rate risk exposure Liability Cash Flows 19

21 Liability-Driven Benchmarks Replicating Portfolio Benchmark benchmark is derived as portfolio of zero-coupon bonds that replicates the liabilities does not work well in practice for long-term liability cash flows zero-coupon bonds do not exist at required maturities Minimum Risk Portfolio Benchmark benchmark is derived from universe of available instruments that minimizes interest rate risk exposure similar to immunization strategy on a specified basis dollar duration, effective duration, partial duration, convexity, etc. 20

22 Duration Matched 400, , , ,000 - (100,000) (200,000) Asset Cash Flow s Liability Cash Flow s

23 Economic surplus exposed to interest rate changes Asset Cash Flows Liability Cash Flows Net Cash Flows Present Value 1,259,979 1,177,505 82,474 Duration Dollar Duration 26,073,803 24,365,528 1,708,276 Convexity (275) 22

24 Interest rate risk exposure to non-parallel yield curve shifts Partial Durations Asset Cash Flows Liability Cash Flows 1 month ( ) ( ) 3 month ( ) ( ) 6 month ( ) ( ) 1 year ( ) ( ) 2 year ( ) ( ) 3 year ( ) ( ) 5 year ( ) ( ) 7 year ( ) ( ) 10 year ( ) ( ) 15 year ( ) year year year TOTAL PARTIAL DURATION SENSITIVITY ANALYSIS 2,000 1,000 - (1,000) (2,000) (3,000) (4,000) (5,000) M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 15Y 20Y 25Y 30 Y 23

25 Asset Management within ALM Framework Focus on financial objectives eliminate bets not being fairly compensated for taking find best risk/reward solution (first optimize on default-free basis) Assets managed directly against liabilities eliminates basis risk associated with using a benchmark aligns portfolio manager incentives difficult for most asset managers => requires sophisticated techniques assets no longer separated => performance measurement not simple No need for client to specify separate investment objectives or try to determine appropriate benchmark ALM drives asset management Greatest chance of achieving overall financial objectives and reducing risk 24

26 Overview of ALM implementation Conduct interviews with Senior Mgt & Key Staff Benchmark Current Practices Define Objectives Assign Roles & Respons. Establish Process Customize Tools & Analytics Develop Risk Reporting Board Approval Draft ALM Policy Statement and Procedure Manual Establish Conceptual Framework Set Org. Structure Identify / Describe Risks Measure Risk Exposure Determine Risk Limits Formulate Strategies Get Buy-In / Establish Risk Management Culture 25

27 Substantial value added through ALM ALM Framework ALM conceptual framework defines financial objectives, risk tolerances and constraints how risk is measured surplus management philosophy *** Critical to get this right *** ALM Policy Statement and Procedure Manual sophisticated tools to manage exposure Integrated with ERM framework for strategic decision making use to achieve financial goals/maximize value reduce risks not being compensated for simultaneously increase returns ALM drives asset management shift focus from asset returns to overall financial objectives ensures portfolio manager s incentives are aligned with company s financial goals 26

28 Substantial value added through ALM Assets managed directly against liabilities liability benchmarks replaced with actual liability cash flows liability-driven benchmarks such as minimum risk portfolio and replicating portfolio benchmarks are tools used to separate asset performance from ALM performance can be gamed absolve portfolio manager from responsibility for overall ALM results value added against benchmark is incremental by nature Disciplined process ALM strategies are formulated to achieve financial objectives impact of trades on ALM results tested prior to execution 27

29 Attribution analysis is challenging 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 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 28

30 Questions? Charles L. Gilbert, FSA, FCIA, CFA 29