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The traditional EV and pricing methodology neglects the effects of interest rate guarantees and other embedded options of Insurance liabilities. In markets which give substantial interest guarantees compared with the Capital Markets interest rate and where Life insurance companies invest a substantial amount of their assets in volatile instruments like shares or real estate, the traditional way of calculating EVs and of pricing products is likely to overstate EVs and to underprice products. Regulatory constraints on the distribution of profits between shareholders and policyholders. Interest rate guarantees Right to stop premium payments. Right to waive planned premium increases. Right to increase insured sums at predetermined levels. Right to purchase annuities at predetermined levels. De facto guaranteed, option-like, profit-sharing policies.
There are several ways to document the output of the risk identification process A simple method is to create tables where each row represents a unique risk and each Manageable risks should be prioritized and assigned to each managerial level in consideration of its priority and scope Where the line is drawn between each level depends on the number of risks, number of management levels and the capacity of management at each level to address risks Regardless of how the risks are assigned, what’s important is not to have risks “slip through the cracks” Just because a risk is not considered strategic does not mean that it should not be managed somewhere in the organization The simplest way to accomplish this is to establish a cross-functional team that reviews the information documented in the prior step and assigns a score to each risk The team should be briefed on management objectives, financial/operational performance metrics, and the risk attributes that should be considered (e.g., likelihood, severity, quality of controls)
Once capital is attributed to each segment and the required rate of return of each segment is determined in relation to risk, a company can measure the value creation or value destruction associated with each business segment. This chart shows the result of such an analysis (or value creation audit) for a company with five major business segments arranged from left to right in declining order of value creation. In this company, A,B, create value while C is at value break even and D and E destroy value. Also note the value destruction associated with excess capital.
I. Assess Risk II. Shape Risk III. Exploit Risk IV. Keep Ahead
5.
When classifying risk factors... … use a scheme that implies action
Known environment
Capabilities and resources on hand to address
Fell between the cracks?
Just get on with it
Unfamiliar territory
Capabilities or resources may not be in place
Major change in market or business
Requires allocation of capital or shift in strategic direction
“ Manageable” Risk Factors
“ Strategic” Risk Factors
6.
Introduce your liabilities to your assets Overview Liquidity Risk Equity or Market Risk Credit Risk Operational Risk Capital
7.
Why do ALM?
These two graphs come from Frank Redington’s essay “Prescience and Nescience”
This essay was written in 1983, 31 years after his 1952 paper on “Immunisation”
Assets and liabilities are durationally matched
8.
Introduce your assets to your liabilities – and gain new insights
“ When I first saw that graph of Ft, I had twenty years of experience of valuation problems. But that was merely knowledge: this graph was different:this was understanding. I still feel the same: that my understanding came with that graph, and has not greatly advanced in the thirty years since then.”
9.
Participating products represent an embedded option because profits are shared 90/10 but losses are carried by the shareholder Investment return Interest rate guarantee Bonus Benefit Shareholder 10% of profits 100% of losses
10.
Unit-linked products can have maturity guarantees Value of funds at maturity guarantee Option premium shareholder benefits
11.
ALM Risk Management Options
Run the Risk
Naked
Hold capital
Transfer the risk
Reinsurance
Securitization
Don’t take on the risk in the first place
Product Design
Hedge the risk
Capital market solutions
Dynamic Hedging
12.
A continual management process is needed to bring the ALM framework to life Set the agenda Establish KPIs Assess Capabilities Build Align & deliver Assess Risks Articulate Strategies Evaluate Strategies Refine Strategies Develop / Refine Best Strategies Implement Strategies Monitor Performance and Environment
13.
A dynamic process is one with a continual feedback loop Policy data Administration system Market Information Risk Tool Hedge Portfolio buy / sell order
14.
Dynamic Hedging Primer - Process
Identify hedge instruments
exchange traded options, futures, cash assets
Portfolio replication for funds offered
managed and index funds
Partition the liabilities into hedge baskets
Calculate the option sensitivity of the liabilities
Determine hedge portfolio
15.
The concept of Dynamic Hedging
Price and Price change of underlying security
Price and Price change of option (guarantee)
constant in small time period t and known
How can O be hedged within t ?
Strategy: Buy units of the underlying S
Call option: positive -> long position
Put option: negative -> short position (“short selling”)
Result:
16.
Option Sensitivities - The Greeks
Call Price = S 0 N(d 1 ) – Xe – rT N(d 2 )
Put Price = Xe – rT N(-d 2 ) - S 0 N(-d 1 )
d 1 = [ ln (S 0 /X) + (r + 2 /2)T ] / T 1/2 , d 2 = d 1 - T 1/2
Delta - Partial derivative of the option value with respect to the underlying asset price ( S 0 ).
Gamma - Second partial derivative of the option value with respect to the price of the underlying asset.
Vega - Partial derivative of the option value with respect to the volatility ( ) of the underlying asset price.
Theta - rate of change of the option price with respect to the decrease in the time to maturity ( T ) of the option
Rho - Partial derivative of the option value with respect to the risk free rate ( r ) used to value the option.
17.
Impact of Dynamic Hedging 20 years, volatility 25%, risk free rate 3.5% p.a., equity linked fund with expected return of underlying = 8% p.a., guarantee = initial investment = 1 1 0
18.
Zoom 1 0
19.
Hedge Effectiveness
Effectiveness = How close is (change in liabilities - change in assets) to zero
Ineffective Hedge
Effective Hedge
All amounts above are the MV of the assets and liabilities
20.
What Can Go Wrong?
Perfect Hedge Unattainable
Merchant bankers are not
charities – beware “no cost” deals
Transaction Costs
Basis Risk
Bulkiness of Hedge Instruments
Liquidity Holes/Market Gaps
Model Risk: Theoretical Prices Vs Market Prices, Assumptions Off => Over/Under Hedged
Volatility Curve Exposure
Cash drain from daily M2M of futures contracts
21.
Stochastic Methods can be Run in a Spreadsheet Generate Asset Returns Read If <limit Summarize STOP Calculate and Write Results Limit depends on the shape of your distribution
22.
Practical Tips
Keep your asset model and liability model separate – people will criticise one or both
Know what you are trying to achieve
Use different asset return models
Concentrate on the process
not the result
Remember – you will always
be precisely wrong
23.
Stochastic results can be powerfully presented in visual formats – no Greeks! Present Value of Distributed Earnings for a Range of Investment Strategies
24.
What does smoothing do?
25.
Does mismatching add extra value?
Conclusion: Mismatching and smoothing can only add limited value unless
you accept a very high insolvency risk
26.
Other Learnings
It is not one bad year but a series of poor years that are the danger
Match assets to your liabilities and mismatch your free reserves
Guarantees make the situation much worse
Can use any asset model
It is fun!
Can also use for reinsurance limits, test assumption ranges, stochastic profit testing and any uncertain values
27.
Liquidity is when market value really counts Overview Equity or Market Risk Credit Risk Operational Risk Capital Liquidity Risk
28.
You need to understand the liquidity requirements of your portfolio – by product
Each major product type should have this graph
If nothing else, separate single and regular premium, because they have a very different liquidity graph
29.
It doesn’t take a lot to get started
Allocate assets to products
Determine period required to liquidate assets
Cash 24 Hours
Shares – T+5, but longer if you have a lot
Property?
Set liquidity standard eg. Must be able to meet two months lapses within 5 days
Factors affecting standard include
Brand attitude
Group issues
Channel
Systems
Monitor actual to standard
30.
Good returns for those who have the skills Overview Equity or Market Risk Liquidity Risk Operational Risk Credit Risk Capital
31.
Credit Risk
Understand the difference between expected and actual income
Don’t give a guarantee without receiving a guarantee in return
Is it worth taking the extra risk?
Is making money from credit risk virtually certain?
Why do such big excess returns occur?
Acknowledgements: Paul Carrett – “Modelling Credit Risk for Australian Fixed Interest Investments” paul_a_carret@national.com.au
But all errors and misinterpretations are mine!
32.
There is a credit risk premium
Does this reflect market inefficiency, or a reward for scarce skills
33.
To understand credit models you need to understand how debt moves between ratings
34.
Not all funds are lost in the event of default
Banks can have offset provisions for other products. This helps improve their recoveries
35.
You can then model your expected portfolio results
One year modelling is not enough time for the full credit picture to come out
Complex and skewed return distributions
transition probabilities
low frequency, high (negative) impact events
Expected returns do not tell us enough
are we observing the mean or the median return?
Need to understand the entire distribution
Warning: Beware of Concentration risks
36.
But good returns can be earned
37.
Some words of warning
Big problems without ratings
The best risks will go to the banks
You may not get complete information
Separate your credit relationship from the total relationship
38.
Understanding operational risk means understanding your business Overview Equity or Market Risk Liquidity Risk Credit Risk Capital Operational Risk
39.
… link to relevant financial measures You need to understand how your risk is built up... SG&A COGS Price Taxes Free Cash Flow Op. Cash Flow Investment Gross Margin Revenues Volume Working Capital Fixed Assets
40.
A more detailed view of assessment and shaping Identify Risk Factors Prioritize Risk Factors Classify High- Priority Risk Factors Model and Quantify Mitigate Strategic Risk Factors Manageable Risk Factors Strategic Risk Factors Manageable Risk Factors Risk Factors That Can Be Mitigated Residual Risk Factors Finance Phase II - Shape Risk Phase I - Assess Risk
41.
Use your experience
Experienced staff know the major risks
Talk about it, set the scene
Look at industry experience
Look at your own experience
Identify risks first – how they can occur
Estimate likely loss
Leave risk mitigation to later
Allow for risk pooling – square root of the sum of the squares
If after the top 5, go for 20 then reduce to 10, this way the top 5 are more reliable
42.
A heat map can then highlight the important risks
43.
Capital is different to negative returns Overview Equity or Market Risk Liquidity Risk Credit Risk Operational Risk Capital
44.
Different parties have a different approach to risk and capital Change in Value of Net Assets Policyholder/depositor security risk relates to insolvency and non-performance Enterprise owner risk relates to performance below target; ends at insolvency
45.
What is Capital?.....it all depends Statutory capital Book capital GAAP capital Economic capital Intellectual capital Physical capital CAPITAL
46.
What is Capital?
Capital is assets less liabilities
This is available capital once required capital is subtracted
CAPITAL
47.
RAROC
Return – Earnings before capital
Required Capital
Equity Risk
Liquidity Risk
Credit Risk
Operational Risk
Statutory Capital can be allocated to above
RAROC = earnings less RC x Required return
In a bank, negative earnings are included in earnings. In a life company deferred acquisition costs can be used
48.
RAROC identifies under-performing businesses units ... Cumulative Value Creation 0 A B C D E Excess Actual Value Creation Cumulative Capital Employed Total Capital Latent Value Creation Under-performing
49.
What we will cover today Overview Equity or Market Risk Liquidity Risk Credit Risk Operational Risk Capital Have a process to cover all risks Introduce your liabilities to your assets Liquidity is when market value really counts Good returns for those who have the skills Understand your business Capital is different from negative returns