ASSET MANAGEMENT

ASSET MANAGEMENTwithin an

ALM FRAMEWORK

Prague, Czech RepublicApril 27, 2007Charles L. Gilbert, FSA, FCIA, CFA

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Focus on asset returns

Assets managed against benchmark– Asset-only benchmark– Liability-driven benchmark

Investment (i.e. asset-only) objectives specified by client

Beating benchmark and/or achieving investment objectives does not necessarily mean financial objectives will be met

Traditional Asset Management

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(80,000)

(70,000)

(60,000)

(50,000)

(40,000)

(30,000)

(20,000)

(10,000)

-

2006

2011

2016

2021

2026

2031

2036

2041

2046

2051

2056

2061

2066

2071

2076

2081

Pension Plan Liability Cash Flows

Duration = 15.4 years

Pension liabilities: long-term and uncertain cash flows

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Asset – Only Asset – Liability

Focus on asset only return / pure asset performanceDoes not capture risk exposureAsset mix determined using efficient frontier

Maximize risk-return trade-off to liabilitiesRisk relative to liabilities more clearly definedRisk to solvency ratios reduced

Liability-Driven Investment (“LDI”) Approaches

Traditional Approach to Pension Investment

Two approaches to managing pension assets

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Strategic asset allocation and selection of benchmark are the major sources of returns and risk– value added by asset manager against benchmark is lower order of magnitude

Investment strategy loosely recognizes risks associated with pension liabilities– investment objective is to maximize expected return for a given amount of risk– equities viewed as a good hedge against inflation, expected to outperform bonds in the long

term

Traditional approach applied to pensions

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E[R]

σ

SAA determined using efficient frontier analysis

Minimize risk for a given level of expected return Maximize expected return for a given level of riskBased on expected return, standard deviation and correlation between asset classes

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Good asset manager can add value vs. benchmark:

Credit quality assessment capabilities based on fundamental analysisTactical asset allocationInterest rate anticipation strategiesOther yield enhancement strategies

Benchmarks selected to manage assets

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Traditional approach for pensions uses asset-only benchmarkBenchmarks include

– market indices• Lehman Aggregate• S&P500

– peer performance• quartile performance

May include duration targetFocus is on total return of assets irrespective of performance of liabilities

Asset-only benchmarks

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Benchmark WeightIndex

PerformanceActual

PerformanceAsset Manager

OutperformanceS&P500 60% 10% 11% 1%

Lehman Aggregate (5 yr duration) 40% 5% 6% 1%Portfolio 100% 8% 9% 1%

Liabilities (15 yr duration) 6%

Solvency Ratio 103%

Asset-Only Benchmark Example:No change in interest rates

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Asset-Only Benchmark Example:Interest rates flatten – long term rates down 1%


PerformanceActual



Lehman Aggregate (5 yr duration) 40% 5% 6% 1%Portfolio 100% 8% 9% 1%


Solvency Ratio 90%

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Funding Ratio - S&P 500 Pension Plans

60%

70%

80%

90%

100%

110%

120%

130%

140%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: Credit Suisse

Asset-only approach exposed pension plans to significant riskSolvency deficits resulted from falling interest rates and stock prices (so-called “Perfect Storm”)

The perfect storm

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Pension crisis could have been avoided Asset-only approach focused on achieving high asset returns irrespective of liabilitiesAsset-Liability approach focuses on achieving asset returns that matchreturns of liabilities

1) increase in asset value greater than increase in liabilities and/or2) decrease in asset value less than decrease in liabilities

Liability-Driven Investment framework

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Liability-Driven Benchmark Example:No change in interest rates


PerformanceActual


OutperformanceS&P500 0% 10% N/A N/A

Replicating Portfolio (15 years) 100% 6% 7% 1%Portfolio 100% 6% 7% 1%


Solvency Ratio 101%

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Liability-Driven Benchmark Example:Interest rates flatten – long term rates down 1%


PerformanceActual


OutperformanceS&P500 0% 10% N/A N/A

Replicating Portfolio (15 years) 100% 21% 22% 1%Portfolio 100% 21% 22% 1%


Solvency Ratio 101%

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Liability-Driven Benchmark plus Beta Example:No change in interest rates / equities +10%


PerformanceActual



Duration 30 yr Pooled Fund 50% 6% 7% 1%Portfolio 100% 8% 9% 1%


Solvency Ratio 103%

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Liability-Driven Benchmark plus Beta Example:Interest rates flatten / equities +10%


PerformanceActual





Solvency Ratio 102%

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Liability-Driven Benchmark plus Beta Example:No change in interest rates / equities – 10%


PerformanceActual


OutperformanceS&P500 50% -10% -9% 1%

Duration 30 yr Pooled Fund 50% 6% 7% 1%Portfolio 100% -2% -1% 1%


Solvency Ratio 93%

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Liability-Driven Benchmark plus Beta Example:Interest rates flatten / equities – 10%


PerformanceActual


OutperformanceS&P500 50% -10% -9% 1%



Solvency Ratio 94%

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New developments focus on Liability-Driven approach

Greater focus on ALM due to financial lossesGlobal shift to marking-to-market of assets and liabilitiesRegulatory pressure to accelerate funding of deficitsNew instruments enabling effective risk managementMove towards Principles-Based Approaches

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Liability Cash Flows

(60,000)

(40,000)

(20,000)

-

20,000

40,000

60,000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

2055

2060

2065

2070

2075

2080


substantial reinvestment rate risk exposure

pre-funding problem

Interest risk remains significant challenge for insurers

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Replicating Portfolio Benchmark– benchmark is derived as portfolio of zero-coupon bonds that replicates the liabilities– does not work well in practice for long-term liability cash flows

• zero-coupon bonds do not exist at required maturities

Minimum Risk Portfolio Benchmark– benchmark is derived from universe of available instruments that minimizes interest rate risk

exposure– similar to immunization strategy on a specified basis

• dollar duration, effective duration, partial duration, convexity, etc.

Liability-Driven Benchmarks

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Duration Matched

(200,000)

(100,000)

-

100,000

200,000

300,000

400,00020

06

2011

2016

2021

2026

2031

2036

2041

2046

2051

2056

2061

2066

2071

2076

2081

Asset Cash Flow s Liability Cash Flow s

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Economic surplus exposed to interest rate changes

Asset Cash Flows


Net Cash Flows

Present Value 1,259,979 1,177,505 82,474 Duration 20.69 20.69 20.71 Dollar Duration 26,073,803 24,365,528 1,708,276 Convexity 520 573 (275)

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Interest rate risk exposure to non-parallel yield curve shifts

Partial Durations PARTIAL DURATION SENSITIVITY ANALYSISAsset Cash

FlowsLiability Cash

Flows1 month (0.00043) (0.00052) 3 month (0.00222) (0.00218) 6 month (0.01327) (0.00831) 1 year (0.05815) (0.03251) 2 year (0.08661) (0.07642) 3 year (0.27027) (0.19842) 5 year (0.46674) (0.37466) 7 year (0.27681) (0.48408)

10 year (0.43401) (0.52143) 15 year (0.78572) 0.46578 20 year 1.54432 2.23528 25 year 6.34456 2.75792 30 year 15.19911 16.93281 TOTAL 20.69376 20.69327

00 7 35 19 106 145

-222

-69

1532

692

-4716

758

(5,000)

(4,000)

(3,000)

(2,000)

(1,000)

-

1,000

2,000

1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y

15Y

20Y

25Y

30 Y

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Focus on financial objectives – eliminate “bets” not being fairly compensated for taking– find best risk/reward solution (first optimize on default-free basis)

Assets managed directly against liabilities– eliminates basis risk associated with using a benchmark– aligns portfolio manager incentives – difficult for most asset managers => requires sophisticated techniques– assets no longer separated => performance measurement not simple

No need for client to specify separate investment objectives or try to determine appropriate benchmarkALM drives asset managementGreatest chance of achieving overall financial objectives and reducing risk

Asset Management within ALM Framework

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Overview of ALM implementation

Establish Conceptual Framework

DefineObjectives

AssignRoles &

Respons.

EstablishProcess

CustomizeTools &

Analytics

DevelopRisk

Reporting

SetOrg.

Structure

Identify /Describe

Risks

MeasureRisk

Exposure

DetermineRisk

Limits

BenchmarkCurrent

Practices

BoardApproval

FormulateStrategies

Conduct interviews with Senior Mgt & Key Staff

Get Buy-In / Establish Risk Management Culture

Draft ALM Policy Statement and Procedure Manual

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Substantial value added through ALM

ALM Framework– ALM conceptual framework defines

• financial objectives, risk tolerances and constraints • how risk is measured• surplus management philosophy

*** Critical to get this right ***– ALM Policy Statement and Procedure Manual– sophisticated tools to manage exposure

Integrated with ERM– framework for strategic decision making– use to achieve financial goals/maximize value

• reduce risks not being compensated for simultaneously increase returns

ALM drives asset management– shift focus from asset returns to overall financial objectives– ensures portfolio manager’s incentives are aligned with company’s financial goals

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Assets managed directly against liabilities– liability benchmarks replaced with actual liability cash flows– liability-driven benchmarks such as minimum risk portfolio and replicating portfolio

benchmarks are tools used to separate asset performance from ALM performance• can be gamed• absolve portfolio manager from responsibility for overall ALM results• value added against benchmark is incremental by nature

Disciplined process– ALM strategies are formulated to achieve financial objectives– impact of trades on ALM results tested prior to execution

Substantial value added through ALM

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Questions?

Charles L. Gilbert, FSA, FCIA, [email protected]

www.nexusriskmanagement.com

ASSET MANAGEMENT

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