ASSET MANAGEMENT

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ASSET MANAGEMENT

  1. 1. ASSET MANAGEMENT within an ALM FRAMEWORK Prague, Czech Republic April 27, 2007 Charles L. Gilbert, FSA, FCIA, CFA
  2. 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 2
  3. 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) 2006 2011 2016 2021 2026 2031 2036 2041 2046 2051 2056 2061 2066 2071 2076 2081 Duration = 15.4 years 3
  4. 4. Two approaches to managing pension assets Asset – Only Asset – Liability Traditional Approach to Pension Liability-Driven Investment (“LDI”) Investment Approaches Focus on asset only return / pure Maximize risk-return trade-off to asset performance liabilities Does not capture risk exposure Risk relative to liabilities more Asset mix determined using clearly defined efficient frontier Risk to solvency ratios reduced 4
  5. 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 5
  6. 6. SAA determined using efficient frontier analysis Minimize risk for a given level of expected return E[R] Maximize expected return for a given level of risk Based on expected return, standard deviation and correlation between asset classes σ 6
  7. 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 7
  8. 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 8
  9. 9. Asset-Only Benchmark Example: No change in interest rates Index Actual Asset Manager Benchmark Weight Performance Performance 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% 9
  10. 10. Asset-Only Benchmark Example: Interest rates flatten – long term rates down 1% Index Actual Asset Manager Benchmark Weight Performance Performance 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% 10
  11. 11. The perfect storm Asset-only approach exposed 140% Funding Ratio - S&P 500 Pension Plans pension plans to significant 130% risk 120% Solvency deficits resulted 110% from falling interest rates and 100% stock prices (so-called 90% “Perfect Storm”) 80% 70% 60% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: Credit Suisse 11
  12. 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 12
  13. 13. Liability-Driven Benchmark Example: No change in interest rates Index Actual Asset Manager Benchmark Weight Performance Performance 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% 13
  14. 14. Liability-Driven Benchmark Example: Interest rates flatten – long term rates down 1% Index Actual Asset Manager Benchmark Weight Performance Performance 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% 14
  15. 15. Liability-Driven Benchmark plus Beta Example: No change in interest rates / equities +10% Index Actual Asset Manager Benchmark Weight Performance Performance 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% 15
  16. 16. Liability-Driven Benchmark plus Beta Example: Interest rates flatten / equities +10% Index Actual Asset Manager Benchmark Weight Performance Performance 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% 16
  17. 17. Liability-Driven Benchmark plus Beta Example: No change in interest rates / equities – 10% Index Actual Asset Manager Benchmark Weight Performance Performance 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% 17
  18. 18. Liability-Driven Benchmark plus Beta Example: Interest rates flatten / equities – 10% Index Actual Asset Manager Benchmark Weight Performance Performance 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% 18
  19. 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 19
  20. 20. Interest risk remains significant challenge for insurers 60,000 Liability Cash Flows 40,000 pre-funding problem 20,000 - (20,000) substantial reinvestment (40,000) rate risk (60,000) exposure 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 2080 Liability Cash Flows 20
  21. 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. 21
  22. 22. Duration Matched 400,000 300,000 200,000 100,000 - (100,000) (200,000) 2006 2011 2016 2021 2026 2031 2036 2041 2046 2051 2056 2061 2066 2071 2076 2081 Asset Cash Flow s Liability Cash Flow s 22
  23. 23. Economic surplus exposed to interest rate changes Asset Cash Liability Cash Net Cash Flows Flows Flows Present Value 1,259,979 1,177,505 82,474 Duration 20.69 20.69 20.71 Dollar Duration 26,073,803 24,365,528 1,708,276 Convexity 520 573 (275) 23
  24. 24. Interest rate risk exposure to non-parallel yield curve shifts Partial Durations PARTIAL DURATION SENSITIVITY ANALYSIS Asset Cash Liability Cash Flows Flows 2,000 1532 1 month (0.00043) (0.00052) 692 758 3 month (0.00222) (0.00218) 1,000 0 6 month (0.01327) (0.00831) -69 - 145 1 year (0.05815) (0.03251) 0 7 35 19 106 -222 2 year (0.08661) (0.07642) (1,000) 3 year (0.27027) (0.19842) 5 year (0.46674) (0.37466) (2,000) 7 year (0.27681) (0.48408) 10 year (0.43401) (0.52143) (3,000) 15 year (0.78572) 0.46578 20 year 1.54432 2.23528 (4,000) 25 year 6.34456 2.75792 15.19911 16.93281 -4716 30 year (5,000) 1Y 2Y 3Y 5Y 7Y 10Y 15Y 20Y 25Y 30 Y 1M 3M 6M TOTAL 20.69376 20.69327 24
  25. 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 25
  26. 26. Overview of ALM implementation Conduct interviews with Senior Mgt & Key Staff Benchmark Assign Customize Develop Define Establish Board Current Roles & Tools & Risk Objectives Process Approval Practices Respons. Analytics Reporting Draft ALM Policy Statement and Procedure Manual Establish Set Identify / Measure Determine Formulate Conceptual Org. Describe Risk Risk Strategies Framework Structure Risks Exposure Limits Get Buy-In / Establish Risk Management Culture 26
  27. 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 27
  28. 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 28
  29. 29. Questions? Charles L. Gilbert, FSA, FCIA, CFA charles.gilbert@nexusrm.com www.nexusriskmanagement.com 29

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