Raoul Berglund, Insurance Supervisory Authority Finland

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Raoul Berglund, Insurance Supervisory Authority Finland

  1. 1. Requiring ALM Policies A Supervisory Perspective Asset Liability Management for Insurance Companies Hosted by the Lithuanian Insurance Supervisory Commission Vilnius, April 16 th , 2004 Raoul Berglund, FASF, CEFA
  2. 2. AGENDA <ul><li>Introduction to the legislative background </li></ul><ul><ul><li>International framework </li></ul></ul><ul><ul><ul><li>Definition of ALM </li></ul></ul></ul><ul><ul><ul><li>EU directives and ALM </li></ul></ul></ul><ul><ul><ul><li>IAIS Supervisory Standard 4 </li></ul></ul></ul><ul><ul><li>The approach adopted in Finland </li></ul></ul><ul><li>Best practice </li></ul><ul><ul><li>The liability report </li></ul></ul><ul><ul><li>The investment policy </li></ul></ul><ul><ul><li>Applied ALM techniques </li></ul></ul>
  3. 3. AGENDA (cont.) <ul><li>Organisation of ALM </li></ul><ul><li>Supervisory issues </li></ul><ul><li>The future </li></ul><ul><ul><li>IAS/IFRS </li></ul></ul><ul><ul><li>Solvency II </li></ul></ul><ul><ul><li>A simple ALM example </li></ul></ul>
  4. 4. 1. Introduction to the legislative background
  5. 5. International framework <ul><li>Definition of ALM </li></ul><ul><li>Asset Liability “Matching” => Asset Liability “Management” </li></ul><ul><li>There is no unique definition of ALM. The following definition is given by the Society of Actuaries: </li></ul><ul><li>   </li></ul><ul><li>“ Asset Liability Management is the on-going process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve financial objectives for a given set of risk tolerances and constraints .” </li></ul>
  6. 6. International framework (cont.) <ul><li>EU directives and ALM? </li></ul><ul><li>No specific reference to ALM exist. </li></ul><ul><li>However, indirectly some basic ALM concepts are addressed. </li></ul><ul><li>Requirement to cover the technical provision by assets (Directives 2002/83/EC article 20 and 92/49/EEC article 15) </li></ul>
  7. 7. International framework (cont.) <ul><li>The ”four pillar” requirement (Directives 2002/83/EC article 22 and 92/49/EEC article 20) </li></ul><ul><li>  </li></ul><ul><li>“ The assets covering the technical provision shall take account of the type of business carried on by an assurance undertaking in such a way to secure the safety , yield and marketability of its investment, which the undertaking shall ensure are diversified and adequately spread .” </li></ul><ul><li>  </li></ul><ul><li> Categories of authorised assets to cover the technical provision (Directives 2002/83/EC article 23 and 92/49/EEC article 21) </li></ul>
  8. 8. International framework (cont.) <ul><li>Rules for investment diversification (Directives 2002/83/EC article 24 and 92/49/EEC article 22) </li></ul><ul><li>The home Member State shall lay down detailed rules fixing the conditions for the use of acceptable assets. </li></ul><ul><li>  </li></ul><ul><li>Assets covering technical provisions must be diversified and spread in such a way as to ensure that there is no excessive reliance on any particular category of asset, investment market or investment. </li></ul><ul><li>  </li></ul><ul><li>Investment in particular types of asset which show high levels of risk, whether because of the nature of the asset or the quality of the issuer, must be restricted to prudent levels. </li></ul><ul><li>  </li></ul><ul><li>etc. </li></ul>
  9. 9. International framework (cont.) <ul><li>IAIS Supervisory Standard 4 (Supervisory Standard on Asset Management by Insurance Companies) </li></ul><ul><li>  </li></ul><ul><li>“ The Board of Directors should be responsible for the formulation and approval of the strategic investment policy , taking into account of the analysis of the asset/liability relationship , the insurer’s overall risk tolerance , its long-term risk-return requirements , its liquidity and its solvency position .” </li></ul><ul><li>(Of interest is also the IAIS guidance paper Stress Testing By Insurers) </li></ul>
  10. 10. The approach adopted in Finland <ul><li>The EU Directives have been implemented as such (the ”four pillar” requirement etc.). </li></ul><ul><li>  </li></ul><ul><li>A separate decree on assets covering the technical provision has been giving (legislator’s view on asset diversification). </li></ul><ul><ul><li>- Very detailed => deep complexity </li></ul></ul><ul><ul><li> - Non-flexible => do not cope very well with new complex investment products and investment strategies. </li></ul></ul><ul><li>  The Finnish Insurance Company Act stipulates that every insurance company must have an investment policy and furthermore that the obligation of the Insurance Supervisory Authority (ISA) is to give regulations concerning the contents of the investment policy. </li></ul>
  11. 11. The approach adopted in Finland (cont.) <ul><li>As the directives, the current Finnish legislation or regulation contains no specific reference to ALM. </li></ul><ul><li>  </li></ul><ul><li>The Insurance Companies Act, however, indirectly stresses some basic ALM concepts. </li></ul><ul><li>  </li></ul><ul><li>Factors that influence the solvency of an insurance company must be managed with respect of safeguarding insurance consumer’s interest by taking into account possible variation of earnings and expenses and other relevant factors . </li></ul>
  12. 12. The approach adopted in Finland (cont.) <ul><li>This statement can be taken, however not officially done so by the legislator , as a requirement of implementing a comprehensive ALM approach. </li></ul><ul><li>ISA’s regulation requires that the appointed actuary must to the Board of Directors give a written statement about the requirements that the profile of the liabilities impose on the assets. </li></ul><ul><li>  </li></ul><ul><li>The appointed actuary must also give a written statement to the Board of Directors that the investment policy fulfils the requirements imposed by the liabilities. </li></ul>
  13. 13. The approach adopted in Finland (cont.) <ul><li>The basic ideas with the appointed actuary’s statements are that the first statement reflects the bridge from liabilities to assets and the second one the bridge from assets to liabilities. </li></ul><ul><li>  </li></ul><ul><li>The reports given by the appointed actuary together with the investment policy approved by the Board of Directors forms an “ALM policy” </li></ul>
  14. 14. 2. Best practice
  15. 15. The liability report <ul><li>Life insurance liability usually have a longer maturity, contains more guarantees and embedded options and tend to be more dependent on economic and financial market performance than non-life insurance liability. </li></ul><ul><li>Therefore the actuarial report of the liability is of greater importance in life insurance. </li></ul><ul><li>The best reports do not only consider what requirements the liability as such impose on the investment activity, but also the enterprise wide factors and objectives that pass requirements on the investment activity through the existence of liability. </li></ul>
  16. 16. The liability report (cont.) <ul><li>Segmentation of liability by </li></ul><ul><ul><li>Product </li></ul></ul><ul><ul><ul><li>Product design can have material effect on ALM </li></ul></ul></ul><ul><ul><li>Maturity </li></ul></ul><ul><ul><ul><li>Expected maturity or contractual maturity? </li></ul></ul></ul><ul><ul><li>Ability to surrender (life) </li></ul></ul><ul><ul><ul><li>“ Sticky” liability vs. “floating” liability </li></ul></ul></ul><ul><ul><li>Currency </li></ul></ul><ul><ul><li>Inflation </li></ul></ul><ul><ul><ul><li>Claims inflation (non-life) </li></ul></ul></ul><ul><ul><ul><li>Inflation linked benefits (life and non-life) </li></ul></ul></ul><ul><ul><li>Technical interest rate </li></ul></ul><ul><ul><ul><li>Guaranteed interest rate (life) </li></ul></ul></ul><ul><ul><ul><li>Discounting (non-life) </li></ul></ul></ul><ul><ul><li>Other guarantees </li></ul></ul>
  17. 17. The liability report (cont.) <ul><li>Embedded options (life) </li></ul><ul><ul><li>Guaranteed minimum payoffs unaffected by changes in market interest rates </li></ul></ul><ul><ul><li>Option to change a fixed rate policy to a unit-linked policy for a certain period </li></ul></ul><ul><ul><li>e tc </li></ul></ul><ul><li>Required return </li></ul><ul><ul><li>Technical interest rate </li></ul></ul><ul><ul><li>Bonus strategy (life) </li></ul></ul><ul><ul><li>Shareholder’s r equired return </li></ul></ul><ul><ul><li>Premium reductions (non-life) </li></ul></ul>
  18. 18. The liability report (cont.) <ul><li>Cash flow projections </li></ul><ul><ul><li>Undiscounted prudently estimated contractual projections (traditional assessment) </li></ul></ul><ul><ul><li>M arket value projections (fair-value like assessment) </li></ul></ul><ul><li>Solvency </li></ul><ul><ul><li>How much investment risk can be taken without jeopardising insurance consumer’s interest? </li></ul></ul><ul><ul><li>Prudent management of an insurance company includes setting own risk tolerance and solvency limits, which should be higher than the statutory ones and in accordance with a long run continuity of the company. </li></ul></ul>
  19. 19. The liability report (cont.) <ul><li>Liquidity requirements </li></ul><ul><ul><li>Under normal circumstances liquidity is no problem (upfront premiums). </li></ul></ul><ul><ul><li>How much should at least be kept in money market in order to smoothly cover expenses and unusual market behaviour that might occur? </li></ul></ul><ul><li>Assets that cover the technical provision </li></ul><ul><ul><li>The growth of liabilities vs. available assets to cover the liabilities </li></ul></ul><ul><ul><li>How much investment risk can be taken? </li></ul></ul>
  20. 20. The liability report (cont.) <ul><li>Diversification of assets </li></ul><ul><ul><li>The statutory rules </li></ul></ul><ul><ul><li>Elimination of possible risk concentration </li></ul></ul><ul><li>Assessment of the most significant liability risks </li></ul><ul><ul><li>Classification of risks </li></ul></ul><ul><ul><li>Uncertainty of made assumptions </li></ul></ul>
  21. 21. The investment policy <ul><li>According to the latest regulation by the ISA the Board of Directors is responsible for formulation and approval of the investment policy and it should cover at least the following areas: </li></ul><ul><ul><li>General principles for the investment activity </li></ul></ul><ul><ul><ul><li>objectives of the investment activity </li></ul></ul></ul><ul><ul><ul><li>the investment return in the short-term and in the long-term </li></ul></ul></ul><ul><ul><ul><li>the principles of diversification , liquidity and counter-party risks </li></ul></ul></ul><ul><ul><ul><li>the principles for the use of derivatives </li></ul></ul></ul><ul><ul><ul><li>the board of directors should annually evaluate </li></ul></ul></ul><ul><ul><ul><ul><li>the risks involved in the investment activity </li></ul></ul></ul></ul><ul><ul><ul><ul><li>the requirements that the profile of the liabilities impose on the investment return, liquidity, currency position </li></ul></ul></ul></ul><ul><ul><ul><ul><li>overall risk tolerance in the short and long-term </li></ul></ul></ul></ul><ul><ul><ul><ul><li>the development of the solvency </li></ul></ul></ul></ul>
  22. 22. The investment policy (cont.) <ul><ul><li>Establishment of limits applied to the investment activity </li></ul></ul><ul><ul><ul><li>The board of directors must in line with the decree on assets covering the liabilities decide the exposure limits for both individual securities and different asset categories. </li></ul></ul></ul><ul><ul><ul><li>Cumulative limits for different risks must also be established, which includes for example risks taken by derivatives. </li></ul></ul></ul><ul><ul><ul><li>Guidelines for the use of possible hedging strategies as part of the general portfolio. </li></ul></ul></ul><ul><ul><ul><li>The management of the currency position must also be included. </li></ul></ul></ul>
  23. 23. The investment policy (cont.) <ul><ul><li>The organisation of the investment activity, delegation of power and reporting </li></ul></ul><ul><ul><ul><li>The board of directors must decide which of the investment decisions are delegated and which of them are not. </li></ul></ul></ul><ul><ul><ul><li>The board of directors should also see to that the reporting of the investment activity is frequent and done in writing. </li></ul></ul></ul><ul><ul><ul><li>The investment policy must also contain a clarification of the use of external asset management service . </li></ul></ul></ul>
  24. 24. The investment policy (cont.) <ul><li>The investment policies typically pay extra attention to the EU “four-pillar” requirement: </li></ul><ul><ul><li>Safety </li></ul></ul><ul><ul><ul><li>The volatility of the investment risk should be kept within available solvency buffer imposed by the solvency requirement or by the insurance company’s own target. </li></ul></ul></ul><ul><ul><ul><li>The safety requirement on assets and the required return from assets covering the technical provision must be kept in balance. </li></ul></ul></ul><ul><ul><ul><li>An assessment of the insurance company’s risk tolerance with respect of both the solvency and the assets that cover the technical provision should be made. </li></ul></ul></ul>
  25. 25. The investment policy (cont.) <ul><ul><li>Yield </li></ul></ul><ul><ul><ul><li>The basic yield requirement (average guaranteed interest rate, average discount rate etc.) </li></ul></ul></ul><ul><ul><ul><li>The yield requirement set by the competition (bonuses, premium reductions etc.) </li></ul></ul></ul><ul><ul><ul><li>The yield requirement set by the shareholder s </li></ul></ul></ul><ul><ul><ul><li>The yield requirement and the safety requirements must be coordinated. </li></ul></ul></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><ul><li>Liquidity of assets (limitation for non-liquid assets) </li></ul></ul></ul><ul><ul><ul><li>Liquidity requirement set by the technical provision (unfavourable claims development) </li></ul></ul></ul>
  26. 26. The investment policy (cont.) <ul><ul><li>Diversification   </li></ul></ul><ul><ul><ul><li>Avoiding risk concentration </li></ul></ul></ul><ul><ul><ul><li>Currency position </li></ul></ul></ul><ul><ul><ul><li>The regulatory principles of asset diversification </li></ul></ul></ul><ul><ul><ul><li>The asset allocation should be dependent on the level of solvency and the profile of the liability . </li></ul></ul></ul>
  27. 27. Applied ALM techniques <ul><li>Conventional strategies (deterministic approach) </li></ul><ul><ul><li>Segmentation of products </li></ul></ul><ul><ul><ul><li>Specific assets back specific products </li></ul></ul></ul><ul><ul><li>Gap buckets </li></ul></ul><ul><ul><ul><li>Matches assets and liabilities by maturity. </li></ul></ul></ul><ul><ul><li>Duration immunisation strategies </li></ul></ul><ul><ul><ul><li>Seeks to match duration of asset and liability cash flows. </li></ul></ul></ul><ul><ul><li>Inflation immunisation strategies </li></ul></ul><ul><ul><ul><li>Seeks to match the inflation risk of assets and liabilities. </li></ul></ul></ul><ul><ul><li>Cash flow matching </li></ul></ul><ul><ul><ul><li>Seeks to exactly match asset and liability cash flows. </li></ul></ul></ul><ul><ul><li>Efficient asset portfolio (mean-variance theory) </li></ul></ul><ul><ul><ul><li>Classical minimum variance asset portfolio optimisation with different constraints (allocation, shortfall, liability growth etc.) </li></ul></ul></ul>
  28. 28. Applied ALM techniques (cont.) <ul><li>Modern strategies (commonly a stochastic approach) </li></ul><ul><ul><li>Cash flow analysis </li></ul></ul><ul><ul><ul><li>Seeks to analyse the uncertainty of asset and liability cash flow estimates. </li></ul></ul></ul><ul><ul><li>Duration and convexity analysis </li></ul></ul><ul><ul><ul><li>Seeks to analyse the sensitivity of assets and liabilities to interest rate changes (beyond parallel shift - key rate sensitivity). </li></ul></ul></ul><ul><ul><li>Stress testing </li></ul></ul><ul><ul><ul><li>“ What if” analysis. </li></ul></ul></ul><ul><ul><li>Value at Risk </li></ul></ul><ul><ul><ul><li>Tries to capture the loss (income statement, investment etc.) for a given confidence interval over some time period. </li></ul></ul></ul><ul><ul><li>Expected shortfall (conditional tail expectation) </li></ul></ul><ul><ul><ul><li>Tries to capture the expected loss (income statement, investment etc.) for a given confidence interval over some time period. </li></ul></ul></ul><ul><ul><li>Value creating strategies </li></ul></ul><ul><ul><ul><li>Tries to increase economic value (the absolute amount of value added to shareholders over a period of several years.) </li></ul></ul></ul>
  29. 29. Applied ALM techniques (cont.) <ul><ul><li>Efficient economic value strateg ies </li></ul></ul><ul><ul><ul><li>Seeks the efficient (minimum variance) economic value asset strategies given a company's liability profile and business plan. (The evaluation is commonly based on consistent valuation of asset and liabilities). </li></ul></ul></ul>Risk Economic Value Current strategy Minimum variance strategy Same risk higher economic value Same economic value less risk
  30. 30. Applied ALM techniques (cont.) <ul><ul><li>Stochastic simulation </li></ul></ul><ul><ul><ul><li>In many cases the complex nature of the products of an insurance company mean that the ALM objectives cannot be solved using a deterministic formula approach . </li></ul></ul></ul><ul><ul><ul><li>Pre-defined scenarios do not help to quantify the level of risk and some less obvious dangerous scenarios may be overlooked . Projecting the company’s results based on a large number of stochastic economic simulations therefore add extra value. </li></ul></ul></ul><ul><ul><ul><li>The most comprehensive models allow for the interaction between assets and liabilities and the ability of the company to take corrective action by changing for instance the asset allocation or bonuses in adverse scenarios. </li></ul></ul></ul>
  31. 31. Applied ALM techniques (cont.) Assumptions Stochastic economic scenarios producing (market consistent) economic variables Parameters (mortality etc.) Liability projections producing simulations of actuarial strategies Asset projections producing simulations of asset mix strategies Range of possible outcomes to be measured Analysis of simulations in line with objectives set Parameters (asset values etc.) Economic link Multi-period decisions
  32. 32. Organisation of ALM
  33. 33. Old Approach <ul><li>Business decisions at functional levels </li></ul><ul><li>The actuarial department focuses on the liability side of the operations and investment department on the risk and rewards of alternative asset strategies and asset classes. </li></ul><ul><li>The modern way is to integrate the various aspects of both sides into an asset-liability management with the goal to achieve financial objectives. </li></ul>
  34. 34. Modern Approach <ul><li>Board of Directors / Top management </li></ul><ul><ul><li>Strong commitment and involvement </li></ul></ul><ul><ul><li>Promote risk management culture </li></ul></ul><ul><ul><li>Statement of principles and objectives with respect of ALM should be documented and approved by the Board of Directors </li></ul></ul>
  35. 35. Modern Approach (cont.) <ul><li>Recourses should be allocated to ALM </li></ul><ul><ul><li>ALM committee (investment committee?) </li></ul></ul><ul><ul><ul><li>Investment and actuarial matters around the same table </li></ul></ul></ul><ul><ul><li>Roles and responsibilities should be well defined </li></ul></ul><ul><ul><ul><li>A sset performance measurement vs. financial objectives. </li></ul></ul></ul><ul><ul><li>Top management should be present </li></ul></ul><ul><ul><li>Strategic and tactical aspects </li></ul></ul><ul><ul><li>Meetings should be held frequently (at least monthly) and documented </li></ul></ul>
  36. 36. Modern Approach (cont.) <ul><li>Independent ALM group or function </li></ul><ul><ul><li>Technical aspects of ALM </li></ul></ul><ul><ul><li>Assumptions and model architecture should be documented well </li></ul></ul><ul><ul><li>Responsible for doing the projections </li></ul></ul><ul><li>Education requirement </li></ul><ul><ul><li>During the recent years the sophistication of ALM has increased </li></ul></ul><ul><ul><li>ALM requires continuous studying, which should be required and promoted </li></ul></ul>
  37. 37. Modern Approach (cont.) <ul><li>Reporting </li></ul><ul><ul><li>Risk management committee </li></ul></ul><ul><ul><li>Top management </li></ul></ul><ul><ul><li>Board of directors </li></ul></ul><ul><li>Frequency of determination (observed) </li></ul><ul><ul><li>Deterministic models usually annually (in connection with formulating the “ALM-policy” </li></ul></ul><ul><ul><li>VaR and expected shortfall weekly to quarterly (solvency and cover of technical provision) </li></ul></ul><ul><ul><li>Stress testing monthly to quarterly (solvency and cover of technical provision) </li></ul></ul><ul><ul><li>Stochastic scenario testing quarterly to annually (depends on market behaviour) </li></ul></ul>
  38. 38. Supervisory issues
  39. 39. Regulatory aspects <ul><li>How should ALM be required? Different approaches exist: </li></ul><ul><ul><li>Set a general requirement to perform ALM </li></ul></ul><ul><ul><ul><li>Wait and see how market practise develops strategy </li></ul></ul></ul><ul><ul><ul><li>The development tends to be slow. Companies tend to apply the same wait and observe strategy. </li></ul></ul></ul><ul><ul><ul><li>A highly flexible approach. I nsurance companies can develop their approach freely without constraints. </li></ul></ul></ul><ul><ul><ul><li>Tends to create set of more variable approaches. </li></ul></ul></ul><ul><ul><li>Set a general requirement to perform ALM companied with guidelines </li></ul></ul><ul><ul><ul><li>An active role by the supervisors in setting market practise. </li></ul></ul></ul><ul><ul><ul><li>Commonly the next step after some market practise have been formed. </li></ul></ul></ul><ul><ul><ul><li>To some level it will harmonise the ALM approaches taken by the insurance companies. </li></ul></ul></ul><ul><ul><ul><li>Requires some knowledge from the supervisors. </li></ul></ul></ul>
  40. 40. Regulatory aspects (cont.) <ul><ul><li>Set a general requirement to perform ALM companied with a set of minimum requirements (and a guideline) </li></ul></ul><ul><ul><ul><li>Taking the earlier approach on step further. </li></ul></ul></ul><ul><ul><li>Set a detailed requirement to perform ALM with a rather strict set up. </li></ul></ul><ul><ul><ul><li>Dangerous! </li></ul></ul></ul><ul><ul><ul><li>Is there a unique ALM approach that would be suitable for all companies? </li></ul></ul></ul><ul><ul><ul><li>Smaller companies can get by with less sophisticated methods. </li></ul></ul></ul><ul><ul><ul><li>Risk of driving the insurance companies all together towards a sub optimal solution (destroying value). </li></ul></ul></ul><ul><ul><ul><li>Requires extremely deep knowledge from the supervisors and the legislators. </li></ul></ul></ul>
  41. 41. Supervision of ALM <ul><li>Holistic supervisory approach is needed which places significant emphasis on the responsibilities of the top management. </li></ul><ul><li>Quality requirement of internal control and risk management should be set. </li></ul><ul><li>Supervisors should have the power to assess the quality of the ALM and it’s processes. </li></ul><ul><li>There is a need for forward looking supervision. Supervisors should therefore promote the use of different ALM techniques. </li></ul>
  42. 42. Supervision of ALM (cont.) <ul><li>Insufficiently flexible supervisors could quickly suffocate financial innovations in a rapidly changing environment. </li></ul><ul><li>However, in areas where a wide range of practise exist, it might be desirable to have a narrower range of practise. </li></ul><ul><li>The applied ALM principles should be sound </li></ul><ul><ul><li>Practices that may be theoretically unsound should be identified. </li></ul></ul><ul><ul><li>Supervisors should be able determine the correct or a more preferable approach. </li></ul></ul>
  43. 43. Supervision of ALM (cont.) <ul><li>There is a need for guidelines both for insurance companies developing ALM systems and for the supervisors to be able to assess the appropriateness of the systems. </li></ul><ul><li>To be effective the supervision of ALM requires a substantial amount of effort and expertise. </li></ul>
  44. 44. Supervision of ALM (cont.) <ul><li>In order to have a holistic and effective supervision of ALM there is a need for a supervisory ALM-team, with expertise in at least </li></ul><ul><ul><li>investment, </li></ul></ul><ul><ul><li>insurance mathematics, </li></ul></ul><ul><ul><li>statistics, </li></ul></ul><ul><ul><li>economics, </li></ul></ul><ul><ul><li>IT and </li></ul></ul><ul><ul><li>internal control. </li></ul></ul>
  45. 45. Supervision of ALM (cont.) <ul><li>However, very often the supervisors are under-resourced, both financially and in terms of experienced personnel </li></ul><ul><li>There is a need to share the knowledge of ALM practices among practitioners and foreign supervisors. </li></ul><ul><ul><li>Does not include specific strategies for managing the exposure or company confidential information and in-depth technical solutions. </li></ul></ul>
  46. 46. The future
  47. 47. IAS/IFRS <ul><li>Key changes compared to the current practise </li></ul><ul><ul><li>Discounting of liability by risk-free market interest rates that reflect the time value of money (risk-free interest rate curve). </li></ul></ul><ul><ul><li>Insurance liabilities are measured as the expected present value of all future cash flows arising from the contractual rights and contractual obligations associated with the insurance contracts. </li></ul></ul><ul><ul><li>I nsurance liabilities should always reflect risk and uncertainty and it should preferably be reflected in the cash flows. </li></ul></ul>
  48. 48. IAS/IFRS (cont.) <ul><li>Thus, </li></ul><ul><ul><li>in principle the method should be a stochastic approach ( probability-weighted arithmetic average of different cash flows at a given date), </li></ul></ul><ul><ul><li>deterministic methods might, however, give results that fall within an “acceptable range” , </li></ul></ul><ul><ul><li>options and guarantees contained in contracts must be valued (as already required by the existing EU directives), </li></ul></ul><ul><ul><li>“ new” calculation methods must be excepted and applied : replicating portfolio, simulation etc. </li></ul></ul>
  49. 49. IAS/IFRS (cont.) Market interest rate € Technical provision according to current praxis Replicating portfolio of the assets
  50. 50. IAS/IFRS (cont.) Market interest rate € Technical provision according to IAS Replicating portfolio of the assets
  51. 51. Solvency II <ul><li>Development of a new more risk-sensitive system for assessing the ”overall” solvency of an insurance undertaking. </li></ul><ul><li>A risk oriented approach, which encourages insurance undertakings to measure and manage their risks </li></ul><ul><li>Should take into account international developments (IASB, IAIS, IAA) </li></ul>
  52. 52. Solvency II (cont.) <ul><li>Three pillar system </li></ul><ul><ul><li>I.Quantitative financial requirements </li></ul></ul><ul><ul><ul><li>regulatory capital requirements </li></ul></ul></ul><ul><ul><ul><li>Internal models </li></ul></ul></ul><ul><ul><ul><li>etc. </li></ul></ul></ul><ul><ul><li>II. Qualitative tools and strengthened supervisory review process </li></ul></ul><ul><ul><ul><li>Principles of internal control </li></ul></ul></ul><ul><ul><ul><li>Principles for sound risk and financial management </li></ul></ul></ul><ul><ul><ul><li>Principles for Asset-liability management </li></ul></ul></ul><ul><ul><ul><li>Harmonised supervisory review process </li></ul></ul></ul><ul><ul><ul><li>Harmonisation of early-warning indicators and reference scenarios for stress tests </li></ul></ul></ul><ul><ul><ul><li>etc. </li></ul></ul></ul><ul><ul><li>III. Market transparency and disclosure </li></ul></ul>
  53. 53. A simple ALM example <ul><li>Assumptions </li></ul><ul><ul><li>Current market value of assets equals market value of liabilities </li></ul></ul><ul><ul><li>Assets are thus sufficient to economically hedge liabilities </li></ul></ul><ul><ul><li>The cash flows from assets and liabilities are as follows: </li></ul></ul>
  54. 54. A simple ALM example (cont.) Time period
  55. 55. A simple ALM example (cont.) <ul><li>Thus, </li></ul><ul><ul><li>there exist a significant reinvestment risk, </li></ul></ul><ul><ul><li>the asset duration is shorter than the liability duration. </li></ul></ul><ul><li>Assume the following hedging strategy: </li></ul><ul><ul><li>A tailored overlay portfolio of interest rate swaps that immunizes the asset/liability cash flow from any changes in level or shape of the interest rate curve . </li></ul></ul><ul><ul><li>The swap extends the duration of the asset portfolio and sets it equal to the duration of the liability. </li></ul></ul><ul><ul><li>The initial effect on the solvency position is zero, since at inception the value of the swap is zero. </li></ul></ul>
  56. 56. A simple ALM example (cont.) Time period Hedged portfolio
  57. 57. A simple ALM example (cont.) <ul><li>In a fair-value world, if </li></ul><ul><ul><li>interest rates increase </li></ul></ul><ul><ul><ul><li>the unhedged portfolio would increase the solvency margin and </li></ul></ul></ul><ul><ul><ul><li>in the hedged portfolio the solvency margin would be unaffected. </li></ul></ul></ul><ul><ul><li>interest rates decrease </li></ul></ul><ul><ul><ul><li>the unhedged portfolio would decrease the solvency margin and </li></ul></ul></ul><ul><ul><ul><li>in the hedged portfolio the solvency margin would be unaffected. </li></ul></ul></ul><ul><ul><li>Hedging is rewarded. </li></ul></ul><ul><ul><li>The reinvestment risk in the unhedged portfolio should be taken into account in the solvency requirements. </li></ul></ul>
  58. 58. A simple ALM example (cont.) <ul><li>According the current accounting praxis, if </li></ul><ul><ul><li>interest rates increase </li></ul></ul><ul><ul><ul><li>the unhedged portfolio would decrease the solvency and </li></ul></ul></ul><ul><ul><ul><li>in the hedged portfolio the solvency would decrease even more. </li></ul></ul></ul><ul><ul><li>interest rates decrease </li></ul></ul><ul><ul><ul><li>the unhedged portfolio would increase the solvency and </li></ul></ul></ul><ul><ul><ul><li>in the hedged portfolio the solvency would increase even more. </li></ul></ul></ul><ul><ul><li>Hedging will not give any reward, on the contrary it might punish. </li></ul></ul><ul><ul><li>The asset profile has no effect on the current solvency requirement. </li></ul></ul>
  59. 59. A simple ALM example (cont.) <ul><li>Conclusions </li></ul><ul><ul><li>T he current accounting praxis and the solvency system does not create proper incentives for ALM. </li></ul></ul><ul><ul><li>The current solvency requirement is clearly incompatible with the fair-value world. </li></ul></ul><ul><ul><li>The results of the Solvency II project will be of utmost importance for the future development of ALM (regardless of the accounting praxis). </li></ul></ul>

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