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ALM in Asset Management CAS Spring Meeting - 20 May 2002

I N S U R A N C E A S S E T M A N A G E M E N T . ALM in Asset Management CAS Spring Meeting - 20 May 2002. Outline. What is the role of ALM in asset management? Definitions Theory Practice New use. Effective Duration. without option. with option. Price. -. +. 0. P. P. P.

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ALM in Asset Management CAS Spring Meeting - 20 May 2002

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  1. I N S U R A N C E A S S E T M A N A G E M E N T ALM in Asset Management CAS Spring Meeting - 20 May 2002

  2. Outline • What is the role of ALM in asset management? • Definitions • Theory • Practice • New use

  3. Effective Duration without option with option Price - + 0 P P P Rate

  4. Liability Duration • Selection of discount rate • Reserves only or include future business • Years of future business • Rate of growth • Expected v. Variable

  5. Yield curve expectations • Duration matching assumes parallel shifts in yield curve • Companies should be indifferent, but … • Companies play directional guessing game • Higher yield  shorter duration • Lower yield longer duration

  6. Bullet • Concentrated around desired duration • Expectation of a flatter yield curve

  7. Barbell • Distributed around desired duration • Expectation for steeper yield curve

  8. Conditional Immunization • Decompose investment into components • Case Cash/Liquidity • IBNR Duration matched fixed income • Surplus Equity/longer fixed income/alternative • Optimal component allocation  sub-optimal overall allocation • Similar to securities on deposit • Transition inefficiencies Liquidity Reserve Surplus 1 Year 5-10 Years

  9. Yield Rolldown - Year 0

  10. Yield Rolldown - Year 1

  11. Yield Rolldown • Obvious extreme example • No credit exposure • Liability Duration decay smaller than Asset Duration decay • Yield curve has positive slope • Liability discount rate not constant

  12. From Theory to Practice • Theory of ALM not applied in practice • Markets aren’t efficient • Markets aren’t complete • Liabilities don’t behave • External restrictions

  13. Bond Price/Index • Bonds traded over the counter • No definite price • Liquidity not guaranteed • Securities not homogenous • Bond index defined by structure - not security • No published list • Broad criteria

  14. Risk Types

  15. Inter-Sector Excess Return Analysis As of 3/31/02

  16. Duration/Sector Allocation

  17. Security Selection

  18. Relative Municipal Yield Nominal vs. tax-equivalent percent yields at 3/31/02 Treasury AAA municipal bond

  19. Avoiding AMT • Determine % income from municipal securities • Expected underwriting • Invest based on BOY assumptions • Mid-year update • 6/30 data available 7/15 • Analysis complete mid-August • Rebalance allocation • Material differences in U/W results require massive rebalancing • Purchases may not be available • Sales might be unprofitable

  20. Conditional Asset Allocation • ALM models used for asset allocation • Expected basis • Catastrophes • Increase short term liquidity needs • Remove need for shielding • Possibly extend duration • Use ALM models to develop liability catastrophe scenarios • Model asset behavior in catastrophes • Develop post-catastrophe allocation • Develop transition plan

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