20.3 Asset-Liability Modeling Approach

9 steps for enterprise-wide model for Asset Liability Management

20.3.1 Step 1: Model Asset Classes, Liabilities, and Current Business Operations

Start with models for the following:

  • Asset classes: interest rate model, stock price model, FX model

  • Liabilities: response to inflation/interest rate or economic variables like GDP growth

  • Business operations: premium, expense, response to u/w cycle and economic environment

20.3.2 Setp 2: Define Risk Metrics

Risk metrics for different accounting basis: Stat, GAAP, Economic

  • Income based metrics

    • \(\sigma\) of income QtQ, YtY

    • Probability of not meeting earning target

    • \(\Delta\) in surplus or equity

  • B/S based metrics

    • Focus on level of surplus or equity of firm

    • \(\sigma\) and probability of not meeting target

    • VaR, TVaR, WTVaR

    • Probability of ruin or impairment

  • Time Frames

    • Typically 1-5 years

20.3.3 Step 3: Return Metrics

Use consistent accounting basis as the risk metrics

  • Income based: Quarterly earnings

  • B/S based: RoE, Terminal value of equity at period end

20.3.4 Step 4: Time Horizon

Single period is simpler

Multiperiod is more accurate

  • More difficult

  • Include serial correlations of variables:

    • Interest rates

    • Level of insurance prices in market

20.3.5 Step 5: Consider Relevant Constraints

Considerations out side of model indications:

  • Asset limits imposed by regulators

  • Cost of regulatory capital of asset class

  • RBC or BCAR capital scores

  • Company’s own investment policy

20.3.6 Step 6: Simulation Model

Consider and varies:

  • U/w strategies

  • Reinsurance options

  • Investment strategies

Risk and return metrics are calculated over these simulations

20.3.7 Step 7: Efficient Frontier Graph

Construction from various portfolio options

  • Based on current portfolio, options with same return but less risk or higher return with same risk should be consider (in between current and the frontier is fine as well)

20.3.8 Step 8: Liabilities

Liabilities (in particular future loss reserves) can be modify as well (besides just assets)

  • \(\Delta\) u/w strategies

  • Reinsurance

    • Should analyze various reinsurance structure and compare results

Important in multiperiod model

20.3.9 Step 9: Review Results

Identify situations that the preferred portfolio performed poorly

  • Develop hedging strategy for those situations

  • Review may highlight type of prevailing conditions that lead to substandard performance e.g. large CAT loss that forces liquidation of assets in soft market

  • Can establish monitoring mechanisms to identify the likelihood of such conditions and make adjustments when they are noticed