ALM or asset-liability management is a fixture in the world of insurance. Does it deserve that status in the context of non-life (NL) insurance liabilities? Life liabilities require ALM focus as they are predominately financial liabilities with similarities to banking – a business that is largely about asset-liability spread management. NL liabilities are for mainly for property and property protection (liability) which have nothing to do with spread management. In this article, I will provide some concepts and insights that I’ve gained from years working with insurers on their investment programs. This article is not a scholarly, heavy math or theoretical discussion, but instead a practical discussion meant to help NL insurer think through ALM.
The Liquidity “Myth”
NL insurers often cite claims liquidity needs when advocating an ALM duration matching approach. The logic is that matching the duration of the A’s and L’s will ensure adequate liquidity to pay claims. Before we get into a discussion on whether duration is the correct metric to focus on, let’s first discuss an NL insurer’s need for liquidity. This is a simple statement that I have long used to highlight why NL liquidity isn’t as important as it may seem:
“Insurers pay yesterday’s claims with today’s premiums.”
I ask insurers to think about that – when did they last have to sell investments to pay claims? The vast majority say never.
To be fair, insurers subject to shock losses like catastrophe reinsurers certainly need to consider liquidity – and tend to keep shorter maturity portfolios. But even they don’t fully match their potential liabilities – as they would be in cash.
Private Markets and Liquidity.
As an aside, it is worthwhile mentioning another area that often creates liquidity questions – investments in illiquid private markets. My counsel to NL insurers has been twofold: First, if you need to liquidate that last X% of your portfolio you are out of business. Second, I believe your real concern, which is a valid one, is really about liquidating ahead of anticipated issues.
Should an NL insurer consider the duration of their liabilities when setting their asset duration? Let’s be clear on what duration is and what it is not. Duration is a metric that indicates how the value of an asset or liability will change when interest rates move. Duration is not a good measure of cash flows or liquidity (cash flows are part of the underlying math BUT they are at discounted values).
Do NL liabilities have duration? Well, it depends on who you are asking…
• The accountants will tell you no, liabilities are carried at gross payout values with no discounting.
• A reinsurer/insurer pricing a loss portfolio transfer would say yes as the loss reserves being transferred are priced (in part) on a discounted basis using current rates.
• An actuary in the pension space would say yes as liabilities are discounted at current rates with changes in rates directly impacting the plan’s funding ratio.
• An NL claims adjuster would probably say that inflation and litigation trends can change the value of the ultimate claims payout – but neither is directly interest rate driven.
So who should you listen to? In my view, the accountant rules as insurers manage to financial statement results. In that framework, NL liabilities are not discounted and thereby have no “accounting duration.” And on the other side of the balance sheet assets are at market values (or market value is disclosed as is the case with Stat) which are affected by changes in interest rates. So A does not live in the same world as L – and L’s world doesn’t utilize the concept of duration. (We will later discuss how to think about A’s world of duration…)
If NOT Liability Duration Then What?
If you’ve made it to this point you are probably both committed to the topic and somewhat confused. I apologize, let’s start clearing that up. In our liquidity discussion, we focused on – well, liquidity. When liquidity is truly needed to pay claims, liquidity should be the ALM metric. That said, there are limited circumstances where that is truly necessary.
• The company or the set of subject liabilities is in run-off (or in decline, e.g. premium volume is being reduced). In that case, the investment portfolio will be utilized to pay claims as new premiums are not sufficient to pay claims.
• Where liability cash flows have significant variability, e.g. CAT reinsurers.
In the first case, a more detailed ALM approach known as a “dedicated portfolio” may be appropriate. That approach involves creating an investment portfolio that has similar cash flows to the underlying liabilities. In the latter case, the insurer may want to limit maturity and target portfolio metrics such as “average life”.
What is a Dedicated Portfolio?
An asset portfolio designed to provide cash flows to defease liabilities as they come due. It is built around “cash buckets.” The concept is to project liability cash flows and group them into cash buckets such as 1-2 years, 3-5 years, 5-10 years, and beyond 10 years. The asset portfolio is then structured to generate cash flows (maturities and coupons) to fill those buckets and fund claims. Detailed modeling of portfolio cash flows (coupons, maturities, prepayments, and calls) underlies such a strategy.
OK, I’m Still Reading –
And I Don’t Know What My Portfolio Duration Should Be
Sorry… Let’s put liabilities aside and look at key risk drivers of a bond portfolio:
- Duration. Market Value sensitivity to changes in interest rates (both risk-free and spreads)
- Default. Risk of principal loss due to non-repayment
- Liquidity. Inability to liquidate a bond at a given point-in-time
Duration is one of the risks inherent to a bond portfolio that needs to be set and managed. NL insurers my first decide on their broad definition of risk. Below I’ve listed my experiences with insurers in priority order.
- Getting downgraded by a rating agency.
- Losing capital (highly correlated with getting downgraded).
- Losing money/accounting income (highly correlated to keeping your job – and highly correlated to losing capital and getting downgraded).
Capital is used to back-stop all risks of an insurer. Investment risk is just one, with duration being a subset of that risk. One can do scenario modeling to evaluate the impact on key capital ratios for interest rate shocks at different levels of duration. Such modeling illustrates how much capital is put at risk for a given duration exposure – and is a useful input to establish a duration target based on risk to capital. The key is:
“Duration is a risk to surplus – and not a risk to claims-paying ability – and should be managed as such.”
• ALM for NL insurers should seldom be based on duration.
• In limited circumstances, ALM for NL insurers is appropriate but should be based on matching liability cash flows.
• Duration is a key risk metric for a bond portfolio. It should be set and managed as a risk to surplus.
• If accounting standards change and liabilities are discounted, the accountants would likely say – tear up this article and start duration matching assets and liabilities!
By DCS Financial Consulting
Steve Doire, CPA, CFA, CPCU, Owner & President
Steve is a recognized industry leader with over 25 years of experience at both an insurance company and in insurance asset management. In addition to being a CPA, CFA, and CPCU, Steve is an insurance solutions expert, partnering with numerous insurers of all types in his career to develop customized strategic investment programs.
He is a frequent contributor to Insurance AUM Journal who shares valuable insights gained from his extensive experience in insurance asset management and with insurers.
Contact Steve at: firstname.lastname@example.org
Disclaimer: Columnist article opinions and viewpoints expressed by the author(s) do not necessarily reflect the opinions, viewpoints nor official policies of Insurance AUM Journal.