### How to perform the Asset Liability Modelling to determine Investment Strategy

How to perform the Asset Liability modelling to determine the investment strategy.

__Asset liability Modelling__

Actuary try to project company’s assets and liabilities into
future and then check whether insurance company has sufficient assets to meet
there liabilities or not. Along with that Actuary also checks whether the solvency
position as required by regulator is satisfactory or not.

Asset liability modelling is a tool to project assets
proceeds and liability outgo into the future that can be used to help in
setting investment strategy to control the risk of falling to meet an
objective.

Now question in your mind would be what is objective?

For ex: Objective can be that assets should be more than
liabilities for the next 10 years with 99.5% confidence interval. In Objective,
we try to make it quantifiable along with time horizon and a defined
probability interval.

**Assets Projection**

Now to project assets we have to see various types of asset
classes such as:

·
Money market instruments (for that we need short
term interest rates)

·
Bonds (for that we need inflation, gross
redemption yield)

·
Equities (we need dividend yield and expected
future growth)

·
Property (we need rental yield and expected
rental growth)

·
Overseas assets (we need future exchange rate
movements and yields in those countries)

First of all, bifurcate all the existing assets in major
asset classes (govt. bonds, corporate bonds, equity and property etc) and
assign expected future returns from each asset class. In case of bonds, we will
also consider proceeds at maturity

While projecting asset values, we need to make following
assumptions:

·
Future interest rates

·
Future inflation

·
Future real yields

·
Rental yields and future Rental growth rates
(for property)

·
Dividend yields and future dividend growth rates
(for equities)

The projection of assets includes both income
(coupon/dividend/rent) and maturity proceeds, if any

**Liability Projection**

·
Liability here means Net liability i.e. Benefit
payments to policyholders + Expenses and commissions incurred in servicing the
contracts + Other insurance related liabilities – Premiums received.

·
Outgoes can be

o
Fixed such as Fixed sum assured in case of term insurance

o
Variable i.e. index linked

o
discretionary for example, bonuses on
with-profit policy

·
Expenses are usually linked to price inflation
or salary inflation. Estimate the expected expenses for the portfolio.

·
The term (i.e. duration) of outgoes depends on
likely timing of the payments.

·
Choose appropriate model points (i.e. * Model
point is a set of data representing a single policy or a group of policies. It
captures the most important characteristics of policies that it represents.)
*which reflects underlying portfolio.

·
Need to make assumptions based on liability. For
ex, if product is annuity then level of longevity, level of annuity increase, taxes
etc.

·
we can then estimate the expected outgoes in
each year.

·
The ALM model can be deterministic or stochastic
depending on the purpose of modelling.

**Determine the Investment Strategy**

·
The Actuary’s initial point for the model would be
to specify the objective. For ex, to
determine an asset allocation / investment strategy such that the probability
of the solvency level falling below x% over the next y years is less than z%. __(i.e.
Solvency ratio falling below 150% over the next 10 years is less than 0.5%)__

·
Given the recent regulatory requirements, the solvency
level might be defined by a regulator * (such as in case of Solvency II)*,
although an in-house valuation basis could also be used

__(such as in case of ECap i.e. economic capital)__·
The model would project the cashflows associated
with the asset proceeds and liability outgo

·
A decision would have been needed as to which
variables to model stochastically and which to model deterministically. For
example,

o
Stochastic modelling for:

§
investment returns

§
inflation.

o
Deterministic modelling for:

§
Withdrawal rates

§
Mortality

§
Expenses

·
Model should exhibit joint relationship between
variables. For ex,

o
Withdrawal rate may be correlated with economic
conditions i.e. in case of economic downturn, withdrawal rates will increase

o
inflation rates and investment returns, bonus
rates and investment returns

·
For the stochastically modelled variables,
probability distributions will have been determined along with parameter values
for ex, mean investment returns / inflation rates, variances and correlations
between variables will be considered. Similarly parameter values for
deterministic modelled variables will be assumed.

·
The actuary would have chosen a trial asset
allocation and carried out a large number of simulations (say 1,00,000) based
on different values generated from the random variables

·
The results of the model will have been compared
with the objective

·
The Actuary will probably have tried many
different asset allocations, leading to a range of potential asset allocation
strategies that meet the objectives.

·
Sensitivity and scenario testing will have then
been carried out on these strategies (__sensitivity testing means checking
the impact on output by changing one assumption or variable at a time. Scenario
testing means by changing more than one variables at a time)__

·
This will have led to a reduced number of
acceptable strategies to be presented to the management. For example strategy
would be

o
50% in Government bonds

o
25% in Domestic equities

o
25% in Corporate bonds

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