Asset/Liability Management (ALM)

18 Pages·2000·0.92 MB·English

RECORD OF SOCIETY OF ACTUARIES
1994 VOL. 20 NO. 1
ASSET/UABILITY MANAGEMENT (ALM):
AN INTERNATIONAL PERSPECTIVE
Moderator: ANTHONY DARDIS
Panelists: DENNISL.CARR
JOHN C.SWEENEY*
Recorder: ANTHONY DARDIS
Lookingat developmentsinEuropeand North America,and consideringboththe
property and casualty andlife insuranceperspectives, this will be awide-ranging
session, covering features such as:
• The historical development of ALM
• Practicalbarriersto implementingALM theory
• New approachestoefficientfrontiers
• Asset/liabilitysurplusmanagement
• Evaluationofcapitalmarkets (economicforecasting,model yieldcurves, and
economic-simulation models)
• Stochasticoptimization
• Sensit'_3/testing of cri'dcalassumptions
• Performancemeasurement
MR. ANTHONY DARDIS: We aregoingto bediscussingoneofthehottesttopicsin
theactuarialworld, asset/liabilitymanagement. Thepanelconsistsoftwo of the
most respectedexponentsof ALM inthe U.S. Iam goingto giveafew introductory
remarks,justto setthescene. ThenDennyCart,oftheARM FinancialGroup,will
giveahistoricalview, andtakealookintothefuture,atleastfortheU.S. Finally,
we'llhaveapresentationfrom JohnSweeney,thechiefinvestmentofficerofthe
USF&GInvestmentManagementGroup. Johnisgoingto saysomethingabout one
ortwo specificmodelingtechniques,andhewillbereferringtohispracticalexperi-
enceinEuropeaswellasthe U.S.
Asa briefintroduction,Iamgoingtoputforwardafew ideasjustto setthe scene.
My commentswill bestructuredaroundfiveheadings.
1. How farshouldALMmodelsgo?
2. A preliminarylookatALMtheory
3. Efficientfrontiers
4. Asset/liabilitysurplusmanagement
5. ALM modelsinpractice
HOW FARSHOULD ALM MODELS GO?
AIM modelscanbeextremelybroadlybased. They canbejustconcernedwith the
fundamental investmentpolicydecisionsastowhat investment categoriesshouldbe
heldandinwhat proportions. Alternatively,you couldhaveavery specificAIM
model. Some modelsmightgo asfarastoselectspecificstocksorshares. So you
*Mr.Sweeneyn,otamemberofthesponsoringorganizationsis,ChairmanofFalconAsset
ManagemenCtompanyandCIOofUSF&GCorporationinBaltimoreM, D.
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can see that the scope for application of ALM models and its implication for the
investment process can be considerable.
A PREUMINARYLOOKAT AIM THEORY
Asset/liabilitymanagementtheoryhasbeenaroundfor manyyears. Redington's
theory ofimmunization,which incrediblyisnowover40 yearsold,isanexcellent
exampleof anasset/liabilitymanagementmodel. Andasa practicalmodeltodate, it
hashadverylittlecompetition. The notionof equatingthemean termof assetswith
themeanterm ofliabilitieshasbeenusedformanyyearsby anumberof insurance
companiesworldwide. Morerecently,thenotionofconvexityhasgivenimmunization
a new leaseonlife.
EFFICIENTFRONTIERS
Theideasunderlyingsomeofthemost advancedAIM theoriesoftodaywerealso
establishedover40 yearsagowiththe conceptsofrisk-rewardtrade-offsandefficient
frontiers. At thetime, thefinancialworldsimplywasnotreadyforthe conceptof
efficientfrontiers,orrather,thecomputerpoweravailableatthe timejusthadnot
reachedthestagewheretheideascouldbeputintopractice. Theefficientfrontier
model isanexample ofavery broadly basedasset/liabilitymodel. Actually, you could
use the concept to make specific stock orbond decisions, but Ithink this would be
extremely dangerous,dueto the diminishingcredibilityof data involved inpredicting
the price movement of individual assets. In any case, the efficient frontier can be
turned into atrue asset/liability model by redefiningrisksoit incorporates the nature
of the liabilitiesaswell asthe nature of the assets. Forexample, we coulddefine risk
in terms of exposure to insolvency, rather than simply asset volatility.
ASSET/LIABILITYSURPLUSMANAGEMENT
Developingfromtheideaofbasingriskonexposureto insolvency,anew concept
hasbegunto appearintheasset/liabilitymanagementliteratureinthe U.S.,thisbeing
the ideaof asset/liabilitysurplusmanagement (ALSM). ALSM isabout asset/liability
management which focuses on the National Association of Insurance Commissioners
(NAIC) risk-based capital (RBC) standards. An ALSM model would then assess how
well the requiredminimum surplus levelsarelikely to holdup usingthe potential
investment strategies up for consideration.
ALM MODELSINPRACTICE
To wrap upthisbriefintroduction,Iwant to mentionanexampleofapracticalALM
model. Ido notproposetogo intoagreatamountofdetailregardingthe modelhere,
whichwas usedinthedevelopmentof auniversaNifeproduct. However, Iwouldlike
to mentionsomeoftheimportantfeaturesofthemodelthat madeit anextremely
useful tool for us.
The companyconcernedwasworriedaboutmarketingauniversal-lifeproductwhere
ithadnoprotectionagainsthavingtocreditvery highinterestrates intimes offalling
assetvalues. Becauseof thisconcern,thecompanywaslookingat incorporatinga
market-valueadjustment. We foundthattheonlyway toreallytest whetherthis
productcouldstandupwithout amarket-valueadjustmentwas to performafullcash-
flow test usinganasset/liability managementmodel. Thisinvolvedmodelingthe
relationship between yields on the particular asset classes up for consideration and the
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ASSET/LIABILITY MANAGEMENT (ALM)
yieldcurvefor Treasuries. Weused40 stochasticallygeneratedscenariosto make
the cash-flow projections for eachinvestment strategy being considered.
There aretwo particular points Iwould liketo mention regardingthis product develop-
ment project. First, we did not makeany attempt at allto dictate anything to the
fund managers. The job of suggestingpossibleportfolios was left entirely to the fund
managers, andthen itwas left to the actuariesto assesswhether the suggested
investment strategies would work within the proposed product design. Second,
reward had nothing to do with returns on assets,per se,but rather, represented the
profitability benchmark that was most interestingto seniormanagement. Also, risk
was implicitly defined interms of whether the reward would be ableto holdup
reasonably,even inthe worst-case scenarios.
Thiswraps up my introductory comments, let usnow move on to the main part of
oursession. Ourfirst speaker isDenny Carr. Denny iscurrently vice president in
charge of product development and asset/liabilitymanagement for the ARM Financial
Group. Heisa member of theInvestment SectionCouncil. Hepreviously worked in
the accumulation products group at CapitalHolding, andpriorto that, hewas a
consultant with Tillinghast.
MR. DENNISL. CARR: My topic isasset/liabilitymanagement inthe U.S., with an
emphasison the past. Ihave beeninvolved inthe asset/liability management practice
areafor over ten years. ALM began, initscurrent form, inthe late 1970s orearly
1980s. There aremany valuablelessonswe can learnfrom history, andmy purpose
isto sharesomeof those with youthroughsomepersonalexperiencesandstories.
The AIM beganinthe late 1970s and early 1980s. The first defining event was the
interest rate spike. Around the late 1970s andearly 1980s short-term interest rates
approached 20% and long-term rateswere 15%. We hadvery high double-digit
interest rates. At that time, we alsostarted a product revolution. We saw the
advent of money market accounts inthe U.S.,which, priorto that time, reallydid not
exist for anyone other than individualinvestors. Also, there was the advent andthe
growth of universallife. It quickly gainedpopularity relative to traditional whole-life-
type forms. Finally,annuities started agrowth spurt at that time. There hadbeen
annuity products priorto this growth spurt, but they took on adifferent form at this
time. The central theme isthat allof the products, including what went on inthe
insurance industry, took on more of an investment element, v_r_hhigh interest rates,
the returns availableonvariousproductsbecame of utmostinterestto everyone.
Duringthis time, we started areplacementtrend. This involved universal-lifeproducts
replacingtraditional products. Thistrend beganmuch soonerthan itwas recognized.
Agents would replaceexisting whole-life contracts, but ratherthan lapsingthem and
havingthat show up asa negative,they would convert them to reduced paid up
insurance and switch their premiumto the new modem universal-life-type contracts,
which were touting double-digit returns. Wehad many reportsthat showed statutory
earnings andpublished earnings, but they reallydid not pick up on whet was going
on. Realcashflow was not growing asmuch asthe salesfiguresshowed. The
lessonisto monitor cashflows becauseaccounting conventions can sometimes hide
what is reallyhappening.
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This alsostarted the eraof shrinkingmargins. Itbecame very competitive. Many of
the pricing elements were stripped out and laid bare to the public in the universal life
type contracts, soprice competition increased.
We also became more aware of the exercise of poficyholder options. This was not
just through surrenders of annuitiesbut alsothrough options that we thought were
safe, such as policy-loan provisionsinordinary lifepolicieswith fixed interest rates of
5% or6%. Iremember SylviaPorter,the financialcolumnist, writing about borrow-
ing against your lifeinsurance at 5% or6% fixed interestand investing ina money-
market account at 15% interest. Insurancecompanies experiencedacash-flow
squeezeasmoney flowed outthrough thepolicy-loan feature. There were some
company failures atthis time; Baldwin Unitedwas oneof the most prominent. Other
companies suffered lesser degrees of financial stress.
As we experienced the interest ratespikeof the late 1970s andearly 1980s, the mix
of businessinthe insuranceindustry was not so annuity-weighted. However, many
companies hadannuity business,andasinterest ratesspikedup,there was much
pressureon that business. Duringthe interest rate spike, Iwas chief actuary for a
medium-sized stock company. Ourchiefexecutive officer, concernedaboutthe level
of surrenders, moved hisoffice to the annuity servicearea,andtalked to annuity
policyholderson thetelephone. That is oneof my memories of the interest rate
spike.
Through the 1970s, we had invested most of the annuity money in long-term bonds
and mortgages. Interest rates hadbeen rather calm. As interest rates madetheir
way into the teens, we agonizedoverwhat to do. Wecould afford to raiseour rates
maybe 50 or 100 basis points, but new money rates were up 500 basispoints. It
was ahelplessfeeling. There hadto be a better way to manage the annuity
business. Fortunately, for myself and for the company, our annuity exposure was not
very large,and we managedto weather the storm.
In 1983, Ijoined Tillinghast andenteredthe glamorous world of consulting. Ihave
labeledthe mid-1980s asthe "reaction period." Severalthings happened in reaction
to the problem of the interest rate spike. First, we saw the adventof the valuation
actuary. Priorto this time, avaluation basicallylookedat the liabilitysideonly.
Reserveswere basedon statutory prescribedminimums andmethodologies that gave
a "conservative reservelevel." The assetside was not reallyconsideredunless
surpluslevelswere tenuous. Ingeneral, we tended to beliabilityfocused on the
valuationside. The valuation actuary concept involved looking at both the assets and
liabilitiesto determine an appropriatereservelevel. Development of new methodolo-
giesand systems alsoflourished inthis era. At Tillinghast, Idecidedthat ALM was a
topic of the future, and it would be a good place to specialize. Istarted working on
systems that allowed you to consider how both the assets and liabilities behaved as
interest rates changed. Priorto that time, most of the actuarialpricing models strictly
looked atthe liability side, Forthe assetsidethe modelspresumed a given interest
rate level, and left it at that. The new methodologies and systems were designed to
take afullerlook at the assetsideandthe interaction that occurredbetween assets
and liabilities.
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ASSET/LIABILITY MANAGEMENT (ALM)
In 1985, the first symposium for the valuation actuary was held. Iwas aspeaker at
the first symposium, and I am going to take you through an illustration that I used in
that presentation. Thepurpose of this illustrationisto point out the needto work
interactively inALM. Thisillustrative company isnamed Mismatch Ufe Insurance
Company. The chief marketing officer is Sal A. Lot. The hero of the story is the
Chief Actuary, EmieD.Spread. Ourthird character is Max M. Yield,the chief
investment officer.
Our story involves a meeting of the interest-rate-setting committee at Mismatch Ufe
InsuranceCompany. They aregetting together to set interest rateson their annuity
products. As usual, Sal,beingthe bashful type, isthe first to speakup. Salsays,
"We've been sellingat agood pace,but we needto keepthat momentum up. Our
chief competitor, XYZ Ufe, iscrediting 6.5% on its annuities. The bottom lineis,we
need to increase our new money crediting rate to 6.35%." Emie speaks up next and
says, "1priced this product and we need 150 basis points to make money. If 6.35%
is the credited rate, we need to earn 8.25% on our investments." At that time, all
eyes tumad to Max, the chief investment officer. Hesays, "There aremanyways to
get 8.25%. You can take credit risk or you can extend your duration and go into
longer maturities." Everyone agrees to credit 6.75%, and the meeting adjourns. This
story was very realten yearsago, and itis stillreflective of the asset/liabilitymanage-
ment used by many companies. How much progresshavewe madeinALM over
the last ten years?
As we moved into the late 1980s we experience the "credit risk crunch." We had
problemswith junkbondsandwith commercial mortgagesthat weredefined asbad
assetclasses. Peoplestartedto measurethe percentageof badassetclassesto total
surplus. There were failures of significant companies such asExecutive Life and
Mutual Benefit. Intheguaranteed investment contract (GIC)marketplace, there was
abig slowdown inbusiness. The "G" inGICdenotes aguarantee, but many started
to doubt the soundness of that guarantee. There was increasedfocus on credit
ratings. We were forced to dealwith ratingagenciessuch asStandard & Poor's,
Moody, and Duff and Phelps. Ingeneral, we hadacredit downgrade for the life
insurance industry.
My last point is beyond interest rate risk. The credit crunch was an event risk in the
credit markets. Evenif you hadthelatest andgreatest interest-rate-riskmodel, itdid
not envisionthis type of event risk. The warning isto becareful forthese "other
risks." When you think you understandeverything that can happen, something new
happens.
The final era, which alsostarted inthe late 1980s andcarded overto the early
1990s, is the bull market inbonds. From 1988-93, yield rateson ten-year Treasury
bonds have declined byover 350 basispoints. Ihaveseveralobservations aboutthis
trend. First, individualannuities generallybecame quite profitable ascredited rates
were cut more quickly than investment earningsdeclined. Spread earningsincreased
on in-force business. Second, not allcompanies were ableto widen their,spread.
The yield on their assetportfolio went down equallyasfast ascredited rates. This
was dueto convexity risk. As interest rates went down, mortgage instruments and
corporate bonds were called andprepaid. Companies receivedcash to reinvestjust
when they least wanted it,with interest rates low andheading lower. Finally,we ran
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intotheinterestrateguarantees. Conservativeratesof4% or 5% became less
conservativeasratesplunged.
Overthepast 10-15 years,annuityreserveshavegrownsignificantly.To illustrate
that fact, let mequotesomestatisticsfromthe AmericanCouncilof Ufe Insurance
(ACLI)fact book. Forthe past15 years,indMdualannuityreserveshavegrownata
compoundannualgrowth rateof between 20% and25%. Groupannuityreserves
alsoexhibitedimpressivegrowth ratesthroughthe mid-1980s. Ithinktheslowdown
overthepastf_e yearshasbeenduetothe creditcrunchinwhichwe sawpeople
movingaway fromGICsastheguaranteebecamemoresuspect.
Another way ofmeasuringthegrowthofannuityreservesisto lookatthechanging
balancesheetof lifeinsurancecompanies.ACLIstatisticsshowthat annuityreserves
as apercentageoftotal lifeinsurancereservesgrew from27% to 67% overthe last
20 years. Anywayyou lookat ittherehasbeenbiggrowth inannuityproducts.
Overthe pasttenyears,Ihaveworkedonasset/liabilitymodelsthat takeintoaccount
interestrate risk,andIhaveheardmanytechnicalpresentationsaboutsuchmodels.
But, when it comesdown to reallyimplementingALM, thereareseveralotherissues
involvedsuchasorganizationalstructure,incentivesandcommunication. The
technologycantakeyou onlyasfarasyourpeopledo.
Oneofthefirstthingswe needto askourselvesiswhat businessarewe reallyin?
Asanindustry,we havetwo-thirdsofour reservesinannuities.Theannuitybusiness
isfundamentallydifferentthanthelifeinsurancebusiness. Intheannuitybusinessthe
keymanagementvariableisthe interestratespreadandthevolatilityofthatspread,
which requiresALM. Forlife insurance,the key managementvariableistheexpense
risk,which includesbothdis'eibutioncostsandotherexpenses.
Anotherkey issueis,arewe organizedto managetheannuitybusinessmostappro-
priately? Letmeillustratewith acoupleofexamplesfrom mycareer. After Ileft
Tillinghast,IjoinedCapitalHoldingaround1988. At that pointintime, Capital
Holdingdecidedto combineitsaccumulationproductsanditsentireinvestment area,
andformaseparatebusinessgroup. Thepurposeofthat businessgroupwasto
managethe interestspread,anditsfocusandincentiveprogramsweredesigned
accordingly.Whilethiscreatedagreatdealofalignment,youstillhadto dealwith
diverseinterests. Overtheyears,Ihavehadthechancetowork withmany invest-
mentprofessionals.Ihaveleamadthat we comefromvastlydifferentworldsin
many ways. Forexample,formost investmentpeople,alongtimeisonehour. For
actuaries,30-yearprojectionsarenotuncommon. Terminologyandtrainingcan
createbarriersto communication. So,eventhoughyouputtheright organizationand
incentivesinplace,morecommunicationisneeded.
Last SeptemberIjoinedthe ARM FinancialGroup. Thisnew venturewillconcentrate
strictlyinthe accumulationbusiness. Weown acoupleoflifeinsurancecompanies,
but ourgoalistowork inandfocusontheaccumulationbusiness.We consider
ourselvesto bespreadmanagersandhavecreatedincentivesforeverybodyinour
companyto managethespread.
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ASSET/LIABILITY MANAGEMENT (ALM)
That isenough aboutthe past. What aresome of the issuesthat we aredealing
with in AIM? The first one isRBC. We have seen trends where companies are
steeringaway from the assetclassesthat have abigcapital allocation attributed to
them.
Thevaluation actuary is now operational. We haveappointed actuariessigning
statements and doing cash-flow testing.
Are we ready if interest rates spike up again? I attended a session on this topic. If
rates go up and stay up for a while, we will seelower earnings fromthe accumula-
tion business. This could be the beginning of our next era--Interest Rate Spike,
Part I1.
Inclosing, Iwould liketo make some comments aboutthe future of ALM. First, if
interest rates riseand they stay up for ayearorso, life insurancecompany earnings
will suffer. V_r_htwo-thirds of our reservesinannuities,andthe spreadstightening on
those reserves, some earningspainis inevitable. Ifrates go up significantly we may
experience some company failures. One of the things I have noticed about AIM is
the realgaincomes from some pain. Many times itwas the failures that caused the
next wave of development andthe next wave of knowledge.
Organizationalstructure will continue to evolve. Peoplewill recognizethat the
accumulation business is fundamentally different from the life insurance business.
Accumulation products will continue to grow, based on the demographics of the baby
boomers.
Advancesintechnologywill provideopportunitiesforus. As Iwasinvolvedoverthe
yearsindevelopingmodels,itseemedthat we wereableto buildmoreandmore
thingsintothemodelsbasedon new chipsfromIntelthat allowedusto runtwo or
threetimesfaster. Eventhoughwe were askingthe modelsto domore,we could
domoreinlesstime becauseofthetechnology. Iexpecttechnologyto continueto
advance. Letmeissueawarning abouttechnology. With high-poweredpersonal
computers,itiseasytodevelopinformationoverload. Youneedto becarefulof that.
Youneedto makesureyouunderstandwhat isgoingon inyourasset/liability
models.
Overtheyears, Ihavenoticedagreat dealof progressinasset]liabilitymanagementin
the insuranceindustry. Frommyperspective,though,Ithinkit isasituationwhere
theglassisstillonlyhalffull. Iseemanyimprovementsareyetto be madethrough
new technologyorthroughpeoplemanagement. We willcontinuetoface new and
challengingenvironments. Iamlookingforward to movingthe scienceof AIM
forward inresponsetothechallengesthatlieahead.
MR. DARDIS: John Sweeneyisthe chairmanof FalconAsset Management,and
chiefinvestmentofficerofthe USF&GCorporation. Johnhasover20 yearsof
economic,financial,andinvestmentexperiencethroughoutthe U.S., Europe,Austra-
lia,Canada,andLatinAmerica. Heisa frequentlectureron investmentandfinancial
issues,andhasauthored,orcoauthored,over40 publishedarticlesandpapers. John
hasbeenquotedand interviewedbysuchpublicationsas The WallStreet Journal,
Barton's, A.M. Best, andPension Wodd.
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MR.JOHN C.SWEENEY: Iwill be providing an overview of theinvestment process
employed by USF&G inthe form of acase study of the evolution of theinvestment
and ALM functions at USF&G's property andcasualty company.
A prerequisite for the AIM processisthe understanding andapproval of senior
management, product-line heads, and actuarial and investment personnel. At USF&G,
the entireinvestment department has abasicunderstanding of allbusinesssegments
with respectto majordifferences, businesscharacteristics, organizationalstructure,
and businessplans andstrategies. Ourinvestment policy statement andguidelines
arenot only written ina corporate context, but also considereachmajorbusiness
segment.
There arefive crucialsteps involvedindevelopingthe assetallocation/asset/liability
processthat we callthe asset/liability management efficient frontier (ALMEF).
1. We needan "economic" evaluationof the balancesheet, an assessment of
the market values of assetsandliabilitiesand adetermination of capital
requirements.
2. Wemust have an evaluationof the capital markets anddetermination of
equilibrium economic assumptions utilizingastochastic economic simulation
model.
3. Obtain optimization of the assetsand liabilities(surplusoptimization) utilizing a
nonlinear optimization model that employs a multiperiod stochastic diffusion
processto generate the asset/liabilityefficient frontier.
4. We needsensitivity testing for keyfactors such asinflation, renewal assump-
tions, loss-ratiovariability, andcapital-market equilibrium factors.
5. The finalstepisthedevelopmentof a performancemeasurementsystem to
evaluateactual performanceversusthe chosen optimal portfolio. The process
loops back to step one at various stages and is reevaluated on an ongoing
basis.
A senior AIM committee has overallALM decision-making responsibilityandapproves
policy, setsguidelinesandconstraints, andevaluatesperformance. Inaddition, lower-
level working committees coordinate efforts, ensure open communication, determine
asset allocation and investment strategy, and contribute to product design and pricing
on abusinesssegment basis. The lower levelcommittees' primaryfunctions involve
analysis,formulation and recommendation of policy and strategy.
This presentation will address only the ALMEF process, although both the aforemen-
tioned prerequisite andongoing issuesarecritical to the success of theALM process.
Chart 1 isaflow chart depicting the ALMEFprocess.
ECONOMICEVALUATION OFTHEBALANCESHEET
Thefirst and most critical stepof the asset/liabilityprocessisthe evaluationof the
balancesheet.
Asset Evaluation
Most companies view theirbalancesheetfrom astatutory or publishedperspective
(i.e., on abook-value basis). However this evaluation must be conducted on a
market-value basis. Inthe long run, amarket-value basiswill providethe best
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ASSET/LIABILITY MANAGEMENT (ALM)
economic benef_. Most companies' assetsconsist of marketable securities. There-
fore,aconversion to market-value basisis relativelysimple with the exception of
investments such as private placements and real estate.
CHART 1
ASSET/LIABILITY MANAGEMENT EFFICIENTFRONTIER
EconomEicvalu_onl
m i
J
The ALMEFmodelusesassetindicesasproxiesfor assetclasses. Athorough
analysis andunderstanding of the key characteristicsof majorassetclassesis
necessaryto ensurethat the proxiesserve asreasonable representationof actual
portfolios. Our fixed income andanalytical model allows usto evaluatethe effective
oroption-adjusted duration andthe four factor duration (parallel,nonparallel,quality
spreadand pass-through spread). Wethen compare key characteristics andreturn
profiles under variousscenariosto proxy indicesthus ensuring that ourproxy indices
serve asreasonablecomparisons to our actualholdings. To approximate the effect of
taxes, the tax-exempt proxy needsto be adjustedaccording to an anticipated tax
profile. Although many otherclassescan bemodified, some assetclasseswe
employed arelistedbelow.
• Fixed Income
-- U.S.Government--Short
-- U.S.Government--Intermediate
-- U.S. Govemment--Long
-- U.S.Corporates--l-5 years
-- U.S. Corporates--5-10 years
-- U.S. Corporates--more than 10 years
-- Mortgage Backed
-- ShortTerm
-- HighYield
• Equities
• Equity RealEstate
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Evaluation
Perhapsthe most difficult aspect of theAUVIEFprocessisthe liabilityevaluation. The
duration measure usedfor property andcasualty liabilitiesis amodified duration,
which isoften referredto interms of ssnsitivityto interest rate change. No single
liabilityduration methodology isnecessarilycorrect; therefore, eachcompany should
resolve the following issuesbasedon itsviewpoint and businesssituation.
1. Is"liquidation" duration or "ongoing"duration more appropriate? Stated
differently, shouldoneexamineonlythe existing balancesheet orconsiderthe
company as a going concern.
2. How is "ongoing" duration derived?
3. How sensitive are the renewal assumptions?
4. What is/arethe appropriatediscountrate(s)?
At USF&G we employ theconcept of "ongoingduration," which isbasedon the
going-concern theory, defined astheeffective liabilityduration giventhe payout profile
of existing reservesandnew andrenewalbusiness. (Liquidationduration considers
the payout pattern of existing liabilitiesonly). Weexecutethe analysis at adetailed
level,by numerouslinesofbusiness,andconsolidatethe resultsby pdmarybusiness
segment. USF&G'schanging businessmixmakes itessentialto develop investment
strategy based on aforward orongoing evaluationof theliabilities. The calculation of
ongoing duration requiresthe support andcooperation of both reserving andpricing
actuaries, business-segmentheeds,andseniormanagement.
When usingthe ongoing duration methodology, adecisionmust be madeabout
factoring inrenewalsonly, new business,orablend of both. Table 1illustrates the
range of liabilitydurationsdependingon themethodology employed. Obviouslythe
methodology employed willsignificantlyaffect the liabilitycash flows, the duration,
and hencethe assetallocation decision.
TABLE 1
LIABILITY DURATIONS--PERSONAL LINES
Method Duration
Liquidationduration 1.5
Includerenewalonly 4.4
Includenew businessforthreeyears,
thenrenewalsonly 5.1
Include new businessindefinitely 10.8
Additionally,the liabilitydurationisextremelysens'_civteo therenewal assumption(s).
Chart 2 illustratesthechangeinpersonallines'durationasafunction ofthechangein
therenewal rate. A 0% renewalrateisequivalenttotheliquidationduration.
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