Asset-Liability Management is a key function in insurance investment management. Insurers’ balance sheets are dominated by Group investments on the asset side and reserves for future claims and benefits on the liability side (ignoring unit linked investments which have identical offsetting liabilities). So, relative changes in value of Group investments relative to insurance liabilities can have a significant impact on shareholders’ equity. As a result, assets must be held not just to cover the expected claims but also unexpected, larger claims and be able to absorb adverse results from any asset-liability mismatch.
The ALM process can be summarized as follows:
Step1: investment objectives and constraints
This is the most important step of the process. Determining investment objectives and constraints is an iterative process. We often revisit this stage as we gain more insight and develop a greater understanding of a portfolio’s risk and return attributes under different scenarios. Importantly, we also analyze the trade-offs of various customized constraints.
Step 2: asset universe and assumptions
In this step, we establish the asset classes to be used in the strategic asset allocation. We believe it is preferable to employ a broad set of investable asset classes to take full advantage of the benefits of diversification and maximize portfolio efficiency. This is achieved through a combination of asset classes with superior principal preservation, risk-return characteristics and attractive correlation attributes. In our view, correlations between asset classes and correlations of asset classes with the liability profile is the key to constructing risk-optimal solutions.
Step 3: liability cash flow and replicating portfolios
Our investment approach explicitly incorporates liabilities as the investment portfolio is required to support liability cash flows. We do this by:
- Understanding the liability profile—Using best estimate liability cash flows, we analyse the liability profile and capture features such as the maturity profile and type of instruments.
- Developing the duration profile—To capture the sensitivity of the liability value to movements and changes to the term structure of interest rates, we construct the overall duration as well as the duration profile of the liabilities.
- Evaluating the current portfolio— It is evaluated whether the current portfolio is sufficiently matched with key economic characteristics of the liabilities including duration and amounts.
Step 4: Risk Measures
In assessing the effectiveness of different investment strategies, our main focus is on understanding the trade-off between risk and return under the primary investment objective. For example, we seek to maintain principal preservation in stress testing of the investment portfolio. Moreover, insurance liabilities are sensitive to many non-market risks such as mortality and catastrophe risk, and may have path-dependent market risk due to dynamic policyholder behavior, crediting rates, etc.
It is vital to see investments as sub part of the broader risk environment.Investment performance and strategy impacts a range of other important areas and is impacted by these broader domains as well.The part of investments in the broader risk context of various stakeholders and macro environment can be illustrated holistically as follows:
ERM must be developed as a process of solvency regulation that allows to look through the front window and see how to identify, assess, monitor and manage risk, as opposed to looking retrospectively at events that have already occurred. ERM is, by its nature, forward-looking; its intent is to link risk regulation to the future strategy of the Company, rather than only applying scrutiny during an assessment or other inquiry. This reduces the silo based approach of seeing risks in a compartmentalized fashion and allows the company to see investment strategy as a sub part of a broader risk management program.