Asset-Liability Management in Life Insurance
The actuarial management of a life insurance business followed a continuous evolution during the past two hundred years. Historically, the life insurance business can be traced to the beginning of the 18th century in the United Kingdom noting in parallel that the first life table was developed by the mathematician Edmund Halley in 1693. In the 18th century the actuary James Dodson did the early attempts to calculate premiums correctly and was followed by his disciple the actuary Edward Rowe Mores who developed a more scientific approach to calculate life premiums. Life actuarial mathematics were further developed by the first modern actuary William Morgan who served until year 1830. Therefore,
since the 18th century the focus was continuously on refining and improving the underwriting, pricing and reserving approaches of life insurance.
Losses were thus seen as emanating from poor underwriting/poor pricing i.e. the key risk was mortality for life products focusing only on mortality.
However, not only did actuarial mathematics keep improving, new generations of life insurance products were pioneered in the second half of the 20th century, which included an investment and even benefit or interest guarantees instead of fixed death benefits.
This necessitated a radical shift in the traditional approach to actuarial mathematics e.g. universal life and unit-linked life products.
In fact, Asset Liability Management (ALM) historically as a science was originally developed to fight the interest rate risk, which became a key concern in the 1970s when interest rates increased significantly and became far more volatile than in the past. In this new, adverse environment, numerous major insurers that had not adequately managed their interest rate risk failed as a result. Reacting to the risk of underwriting interest-sensitive products, insurance supervisory authorities (regulators) began requiring insurers to perform a basic annual analysis to prove their interest rate risk management.
Assets and Liabilities have therefore to be managed together in a coordinated manner as a solution. According to the Society of Actuaries:
“Asset Liability Management is the ongoing 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”.
An insurer that is not able to coordinate its decisions on assets and liabilities will be exposed to great difficulty. The following example of the bankruptcy of a Japanese life insurance company illustrates as a start the typical scenario of Asset/Liability failure and is the best example given for explanatory purposes for the necessity of appropriate ALM in a life company.
Nissan Mutual Life, a Japanese company with 1.2 million policyholders and assets of JPY 2 trillion (USD 17 billon) offers a case in point. The company sold individual annuities paying guaranteed rates of 5 to 5.5 percent without hedging these liabilities. A plunge in government bond yields to record low level created a large gap between the interest rates Nissan Mutual committed itself to pay and the return it was earning on its own investments. On 25 April 1997, Japan’s Finance Minister ordered the company to suspend its business. Nissan Mutual was the first Japanese insurer to go bankrupt in five decades. Its losses totaled JPY 300 billion (USD 2.5 billion). This episode illustrates the need for insurers to carefully coordinate their management of assets and liabilities1.
Thus, Interest rate risk that is a major market risk has two main components: Disintermediation risk, which is the risk of having to sell assets at loss to fund substantial cash outflows; Guarantee risk, which is the risk that interest rate guarantees will exceed interest rates earned2.
The three most acclaimed ALM methods have been Cash Flow Matching, which is the most intuitive, Cash Flow Testing, which is more dynamic and Duration Matching, which captures multiple years of cash flows and their sensitivity to timing and interest rate.
First, Cash Flow Matching implies that at each time period, the asset cash flow will exactly match the negative cash flow arising from the liabilities. If achieved properly, the manager would have eliminated all the interest rate risk from this business.
Second, in 1993, the National Association of Insurance Commissioners adopted a Standard Valuation Law requiring insurers to perform Cash Flow Testing to verify that they hold sufficient reserves. This technique calls for a forecast of the assets, liabilities and investment management decisions under a variety of scenarios.
Third, duration matching is also known as immunization. The idea is to protect, or “immunize”, against losses caused by a change in interest rates. This is accomplished by structuring a portfolio so that the impact of a change in interest rates on the value of liabilities offsets the corresponding impact on asset values. Frank Redington the famous actuary laid the foundation for this science. A foundation paper by Redington recognized that the business on the books of a life insurer at any valuation date would produce two series of payments, which could be described as follows: Liability outgo (the net outgo in future years from existing business – that is, claims and expenses less premiums), which may be either positive or negative, and Asset proceeds (interest plus maturing investments in future years from existing assets)3
ALM is often performed by combining the results of the different ALM techniques mainly Cash Flow Matching, Cash Flow Testing, Duration Matching and Stochastic ALM.
The ALM strategy will heavily rely on sound quantitative and business judgment.
Later on beginning with the 1990s, the rapid consolidation of the life insurance and reinsurance industry that created unprecedented gigantic life portfolios, the increasing reliance on stochastic modeling instead of deterministic models and the significant progress of computing capabilities shifted actuarial management to overall Enterprise Risk Management. An increasing number of actuaries embraced the risk management profession. Not only assets and liabilities have to be coordinated the entire spectrum of risks has to be managed by an overall ERM strategy given a risk appetite.
Insurance Enterprise Risk Management went further by coordinating and modeling all risks altogether including operation, market, and insurance risks.
Economic capital models gained momentum. Stochastic modeling and computer capabilities have significantly progressed since the first ALM models were introduced. However, stochastically based economic capital models did not prevent the financial crisis in 2008 but the importance of risk management was reinforced after the crisis. We note the attempt of the International Association of Insurance Supervisors in launching a common framework for the solvency capital for systemically-important insurers. Furthermore, the solvency II in Europe is part of this evolutionary path of the approach to risk toward risk-based models.
Even today, Assets and Liabilities are still regarded as two separate elements and Asset/Liability reasoning remains the field of a limited circle of actuaries in large life insurance companies. But the Investment Manager has his own profession as a Finance professional and the Reserving Actuary has his own profession as an Actuarial Professional. In addition, Asset/Liability approaches are performed by the actuarial professional as he moves towards the investment field out of his traditional role as pricing or reserving actuary. Asset Liability Management in life insurance has taken an evolutionary path but some initial ALM concepts will always remain relevant.
Despite the shift in the risk management landscape, the fundamentals of Asset Liability Management remain a key element of the actuarial management of a life insurance portfolio.
ALM remains a key tool in the ERM strategy of a company.
1 Sigma Issue on ALM - Swiss Re
2 “Life Insurance Products and Finance” textbook of the Society of Actuaries
3 Actuaries and the Creation of Financial Security – Derek Renn – Blackwell publishers 1998