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Insurance asset liability management (ALM) is the process of studying an insurance company’s exposure to asset and liability risk, defining its risk tolerance and its financial goals and planning the actions it should take in order to limit its exposure while reaching those goals. Life insurers are particularly exposed to asset and liability mismatching given the long-term nature of their engagements. To better assess and manage risks, insurers look at asset and liability duration. Scenario testing and dynamic financial analysis are two techniques used in insurance ALM.
Insurance ALM risk is the risk incurred when asset and liabilities terms are mismatched, forcing the company to buy and sell assets, or to take on liabilities, when conditions are unfavorable. The most common ALM risks are two types of interest risk. The first is reinvestment risk, when assets must be invested when interest rates are low and asset levels are high. The second is disinvestment risk, when assets must be sold when prices are low and interest rates are high. Managing other risks such as currency risk, equity risk and sovereign risk also are considered part of insurance ALM strategy.
Spearheaded by banking institutions in the 1970s when interest rates abruptly became volatile, interest risk management became a major concern for life insurance companies, giving rise to insurance ALM. Life insurance premiums are locked for as many as 30 years, so insurers must find investments with stable yields for the lifetime of these policies. Reinvestment risks are apparent, because future premiums must be invested even if their rate of return is lower than the rate necessary to cover present-day pricing. Likewise, insurance companies are exposed to disinvestment risk, when assets must be sold even at low prices to cover claims or other expenses. The impact of rising interest rates can be compounded by lost profits from suspended policies as consumers search for more lucrative financial instruments.
The foremost tool used in insurance ALM risk assessment is a metric called duration, which measures an asset’s sensitivity to changes in interest rates. Positive duration means price and interest rates are inversely proportional; an asset’s price increases when interest rates drop. Negative duration means that price and interest rates are directly proportional; an asset’s price increases when interest rates increase. Convexity, which is the rate of change of the duration, also is used to assess interest risk.
Many risk management strategies are employed to reduce interest risk, including dedication and immunization. Dedication is when companies match cash inflows from their assets with cash outflows from their liabilities, insulating themselves from the effects of interest rate changes. Although dedication ideally reduces exposure to interest risk, it is very difficult to predict cash flows accurately. Immunization is when companies match the durations and/or the convexity of their assets and liabilities. The difficulty of immunization is finding and understanding adequate combinations of assets and liabilities that comply with the industry’s solvency requirements.
Non-life insurance companies typically address the impact of ALM risks at the enterprise level, analyzing their financial stability as a whole instead of devoting specific resources to insurance ALM. They use dynamic financial analysis (DFA), which is an approach that simulates thousands of random scenarios of the company’s earnings. This is an improvement from the deterministic approach called scenario testing typically used in life insurance, which relies on the skill and experience of the insurance management team to choose the best, worst and most likely scenarios.