Issues Paper

INTERNATIONAL ASSOCIATIONOF INSURANCE SUPERVISORSISSUES PAPER ON ASSET-LIABILITYMANAGEMENTOCTOBER 2006

This document was prepared by the Solvency and Actuarial Issues Subcommittee in consultation with
IAIS Members and Observers.
This publication is available on the IAIS website (www.iaisweb.org).
© International Association of Insurance Supervisors 2006. All rights reserved. Brief excerpts may
be reproduced or translated provided the source is stated.

Issues paper on
asset-liability management
Contents
1.

Introduction.................................................................................................................................... 3

2.

Risks Covered by ALM.................................................................................................................. 33.

ALM for Different Product Lines .................................................................................................... 74.

ALM Measurement Techniques .................................................................................................... 95.

ALM Management Techniques ................................................................................................... 13

Appendix- Definitions............................................................................................................................. 18

1. Introduction
1. This issues paper complements the IAIS Standard on asset-liability management (2006)(herein referred to as the ALM Standard) by providing additional background and detail about
asset-liability management. As noted in the ALM Standard, insurers should select assetliability management strategies and techniques that are best suited to their particularbusiness. Insurers need to acknowledge the various trade-offs made between risk and returnin selecting their methodologies. For example, a non-life insurer with short term liabilities
might invest the supporting assets in instruments of a short duration. The insurer would thus
lower its risk profile, but also reduce the potential return on the assets.
2. As outlined in the ALM Standard, there are a number of other IAIS papers which should
be referred to when studying ALM including: IAIS Insurance core principles and methodology(2003); Standard on asset management by insurance companies (1999); and the Guidance
paper on investment risk management (2004).

2. Risks Covered by ALM
Market Risk
3. As described in the ALM Standard, market risk includes:
•

•

•
•

interest rate risk (including variations in market credit spreads): risk of losses resulting
from movements in interest rates and their impact on cash flows. To the extent that
future cash flows from assets and liabilities are not well matched, movements ininterest rates can have an adverse economic impact.
equity, real estate and other asset risks: risk of losses resulting from movements ofmarket values of equities and other assets. An insurer can be exposed to adverse
economic impacts to the extent that the market values of equities, real estate and otherassets held do not move in line with liabilities.
currency risk: risk of losses resulting from movements in exchange rates. To the extent
that cash flows, assets and liabilities are denominated in different currencies, currency
movements can have an adverse impact on the insurer.
related credit risk: in coordinating its exposure to market risk an insurer may increase
its exposure to counterparty credit risk.

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4. As defined in the IAIS Glossary, market risk incorporates general market risk (on allinvestments) and specific market risk (on each investment). It includes the exposure ofderivatives to movements in the price of the underlying instruments or risk factors. Market
risk also includes exposure to other unanticipated movements in financial variables or to
movements in the actual or implied volatility of asset prices and options. Market risk may belinear, non-linear or geared. Exposure to non-linear or geared market risk arises typicallythrough the use of derivatives. In times of significant economic turmoil asset correlations tend
towards 1 or -1. During such times the risk reduction benefits of diversification may
temporarily disappear and there may be serious financial consequences.
5. An insurer should be able to measure its market risk exposure across risk factors (e.g.,interest rate, equity and currency) and across the entire portfolio. The insurer should set
appropriate metrics to measure exposure to market risk factors.
6. Market credit spreads can be a major source of market risk. For example, insurers may
invest substantially in corporate bonds to take advantage of higher returns on lessmarketable securities, for example if they have liabilities that are illiquid or discretionary.
Interest rates may be affected by changes in general credit market conditions and lead towidespread credit downgrades and to spreads varying substantially according to the rating of
the bonds, especially in extreme scenarios. In some jurisdictions it is permissible to achieve
greater flexibility in managing this risk by holding a replicating portfolio of government
securities together with credit derivatives.
7. The modelling of the interest rates should include scenarios of a shift, a twist and bends1of the yield curve, individually and in various plausible combinations.
8. An insurer with a complex portfolio would be expected to demonstrate moresophistication in its modelling (e.g., stochastic interest rate modelling) than an insurer with asimple portfolio. Sometimes the insurer may decide to trade-off sophistication and accuracy
in favour of simplicity and conservatism. Decisions taken in this regard should be transparent– i.e., clearly understood and documented.
Underwriting Risk - Policyholder Options
9. Insurance contracts may offer policyholders choices, such as settlement options, policy
loan options, over-depositing options and surrender or renewal privileges. These embedded
options provide policyholders added flexibility. However, if not managed properly they could
result in additional costs to the insurer over the life of the policy and potentially a liquidity
cost.
10. The insurer must understand the types of embedded options that exist in new and inforce policies and their possible effects on ALM. The insurer must manage its assets and1

A shift means a parallel displacement of the yield curve (i.e. returns of all maturities rise or fall to the same
extent). A twist means a turn of the yield curve (i.e. the same change of the slope of the yield curve isobserved). A bend means that returns of shorter and longer maturities move in the opposite direction thanreturns of average maturities (i.e. the curvature of the yield curve changes).

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liabilities in a way that would mitigate the risks, recognising that these risks are generally notdiversifiable.
11. Options commonly embedded in insurance contracts that should be considered by the
ALM include:
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•
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•
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investment products that guarantee the return of policyholder capital on maturity or
early termination. This option can affect persistency.
settlement options that allow the beneficiary to choose to have the benefit payment in
the form of either a lump sum or an annuity. The former requires liquid assets whilewith the latter there may be a problem obtaining assets to match long durations.
an accumulation annuity contract that may give the policyholder the option of choosing
a cash payment at maturity or an annuity at pre-specified interest and mortality rates
an accumulation annuity contract that allows a book value cash-out option to thepolicyholder at any time, not just at the maturity datea policy loan option that allows the policyholder to borrow, at any time, at specified
terms, against the cash value of an insurance policy
an over-deposit option that allows the policyholder to pay premiums higher thanrequired, which will be credited at a pre-specified rate of interest
a surrender privilege that allows the policyholder to halt the insurance contract
prematurely, to stop paying premiums and to collect any cash values
a renewal privilege that offers policyholders the right to either renew the insurance
contract at pre-specified rates or to halt the agreement at the end of the policy period
credited rates on liabilities that influence the lapse rate and which in turn may require
either unexpected liquidation or reinvestment of assets.

Certain trigger events, such as the insurer receiving a downgrade from a rating agency orother adverse reputational events, can result in a higher level of policyholder surrenders,
especially by institutional policyholders. This could lead to liquidity problems.
Underwriting Risk - Impact of new business12. Insurance and investment products are continually being introduced, redesigned,
replaced, expanded or updated. Where relevant, an insurer’s ALM process should ensurethat the pricing, product development and investment departments work closely together.
Features offered to policyholders must be well understood so that products are priced
properly and the accompanying investment strategy is appropriate. In particular, well defined
investment benchmarks and strategies should be established.
13. Given the relevant new product characteristics, the insurer’s investment department
should determine whether assets of the term, quality and yield required to meet the future
cash flow and solvency requirements are available. In addition, it should assess whether
these assets will continue to be available. When suitable assets are not available, the insurer
may need to substitute, permanently or temporarily, assets that do not meet its requirements.
This may result in yields insufficient to produce an interest margin, or delays between receipt
of premiums and investment in assets that could subject the insurer to interest rate risk.

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Liquidity risk
14. Liquidity risk is exposure to loss in the event that insufficient liquid assets will be available
from among the assets supporting the liabilities, to meet the cash flow requirements when
they are due. This may force insurers to sell other assets at unfavourable prices. The liquidity
profile of an insurer is a function of both its assets and liabilities and varies with market
conditions.
15. To the extent that they are predictable, immediate demands on cash should not poseundue liquidity risk for an insurer. Any immediate demand for a cash payment can be a risk if
cash is in short supply. A well-managed insurer will structure its assets so that it has enoughcash and marketable securities to cover its obligations when they arise. The insurer may
have the ability to reduce payments to surrendering policyholders to reflect adverse market
conditions, so that assets can still be matched to the expected duration of the liabilities.
There is also sometimes the possibility of timing the payments to policyholders (at least forindividual life policies) so that payments are not made until the corresponding assets havebeen sold.
16. The following are some of the potential causes of liquidity problems for insurers:
•
•
•
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•
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•
•
•
•

a deliberate mismatching strategy
affiliated investment risk: the risk that an investment in a member company of theconglomerate or group may be difficult to sell, or that affiliates may create a drain on
the financial or operating resources of the insurer
funding risk: the risk that the insurer will not be able to obtain sufficient outside funding,as its assets are illiquid, at the time it needs it (e.g., to meet an unanticipated large
claim)
liquidation value risk: the risk that unexpected timing or amounts of needed cash may
require the liquidation of assets when market conditions could result in loss of realisedvalue
negative publicity (which may cause increases in lapsed policies)a large unexpected loss which is payable immediately
delays in payments from reinsurers
policyholder actions
deterioration of the economy with abnormally volatile or stressed markets
political and legal risk, from unforeseen changes in legislation and court awards
investments that cannot be sold due to linked relationships with other companies
several insurers facing large unpredictable demands on liquidity at the same time andneeding to liquidate some of their asset portfolios, with the result that the marketplaceis unable to absorb the volume other than at unfavourable prices.

17. An insurer should structure its assets to meet its expected short term liability cash flows.
An insurer should have a plan for how to deal with unexpected cash outflows - either byholding additional liquid assets or having an emergency credit facility.
18. The size or credit rating of the insurer, its status (e.g., as a mutual insurer) and/or local
regulation, may limit its access to funding. If an insurer is too small, it may not have thefunding choices that are available to larger insurers.
19. Where permitted and subject to conditions set by the supervisor, borrowing can be an
important aspect of an insurer’s ALM strategy. However, insurers should be cautious inrelying on this source of liquidity. For example, following an insurance risk event (e.g., a
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catastrophe or large claim), banks may be unwilling to lend to an insurer. Where possible,
formal credit lines should be established that could mitigate that risk. Such credit lines should
also be sufficiently diversified to reduce the concentration risk to financial institutions which
may also incur losses in extreme circumstances.
20. Lack of diversity in either the liability or the asset portfolio when analysed by product,
geography, industry or creditor can lead to increased liquidity risk. An over-concentration of
illiquid assets, such as real estate, thinly traded securities or structured investment products,
may be especially risky.
21. Each insurer should select appropriate measurement tools, such as liquidity ratios andcash flow modelling, to determine its exposure to liquidity risk; there are no simple formulaethat work for all insurers. For further information, liquidity measurement techniques are
discussed in the IAIS Guidance paper on investment risk management (2004).
22. Insurers may be able to obtain emergency liquidity funding in the event of a catastropheby drawing cash early under their reinsurance policies or by other means. This could berecognised when assessing the amount of liquidity available to meet the level required.

3. ALM for Different Product Lines
23. ALM strategies differ by line of business. The examples given below are for illustrative
purposes only, as products may differ by jurisdiction.
Accumulation Annuities, Deferred Annuities
24. ALM is important for financial intermediation products. Profitability on accumulation ordeferred annuities depends on the rates of interest cash inflows can earn. The margin on the
spread of the rates of interest is relatively small; thus ALM is critical to maintain profitability.
These products may be regular or single premium business, usually with a selected maturity
date and can be relatively short-term, for example, five to ten years. Therefore, the risks may
be relatively easy to manage. The ALM becomes more complicated, however, if the producthas policyholder options for early surrender without a market value adjustment, guaranteedinterest rates for future premium deposits or guaranteed cash or annuity options at
retirement.
Deposit Funds
25. An insurer may choose to maintain an unmatched asset-liability position for some productlines. For instance, a daily interest fund is cashable any time at the option of the policyholder.
While it would be conservative to maintain the supporting assets totally in cash, a longer
asset duration is justifiable since experience shows that not all policies are immediately
cashed out. For these products, pricing and guaranteed rates must respond quickly tochanges in market interest rates, because stale rates will produce losses if rates are too high,or poor sales if rates are too low.
Payout Annuities, Lifetime Annuities, Immediate Annuities
26. Like accumulation annuities and deferred annuities, payout annuities are priced as
spread business and their profitability depends on the rates of interest the cash inflows earn.
Since the interest rate spread is relatively small, ALM is critical to maintaining profitability.

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These products are usually single premium business and have no fixed maturity date. They
may have very long durations and may not be totally duration matched with assets at issue.
The ALM then has to take into account future reinvestment risk as well as mortality risk.
Where insurers use equity or real estate investments as part of the ALM for the long duration
terms, the risks associated with these investments must be considered and monitored
carefully in light of the entity’s risk tolerance.
Non-Participating Permanent Insurance
27. Non-participating life insurance policies include whole-life or endowment type products
comprised of long-term liabilities, as well as universal life or unit-linked products. ALM for thisbusiness should include the probable cash flows associated with mortality and surrender ofthe policy. In addition, ALM cash flows should include assumptions for future premium cash
flows and a suitable range of future reinvestment rates. For example, universal life2 or unitlinked products can include a number of features that make cash flows difficult to predict,such as the policyholder options to suspend premium payments for some periods or to makeinfrequent larger-than-normal payments.
Participating Insurance, With-Profits Insurance
28. These products are designed so that the policyholder shares the risk and participates in
the profit from the business. ALM for participating, with-profits life insurance should include
assumptions for future policyholder bonuses/dividends based on reasonable policyholder
expectations, as well as for the underlying guarantees that will emerge as policies mature.
Since these bonuses/dividends can be altered to take account of changes in interest rates orother cash flows, there could be greater investment freedom than for non-participatingproduct lines. However, the insurer does not have complete discretion and will need todemonstrate that policyholders continue to be treated fairly and that guarantees areadequately covered. Furthermore, policyholders’ expectations and marketing considerations
may make it difficult for the insurer to fully reduce benefits if risks do materialise. As
jurisdictions move towards more transparent and explicit treatment of policyholder
bonuses/dividends, ALM is a natural tool to use to determine appropriate asset allocation.
Unit-Linked Products and Variable Annuities
29. Some product lines include a link between policyholder funds and external equity or bondmarkets or indices. ALM should examine the relationship between contractual andconstructive3 liabilities and assets held to back those liabilities. Supervisors have taken
different approaches to regulating these products: and some jurisdictions require that there
be no ALM risk in the management of such funds (e.g., by requiring that unit-linked liabilities
are covered as closely as possible by matching assets). Some products may also haveguaranteed payouts at maturity which may give rise to additional ALM issues.

2

Universal life is a combination flexible premium, adjustable life insurance policy. The policyholder may selectthe amount of premium he or she can pay and the policy benefits are those which the premium will purchase.
Or, the premium payer may change the amount of insurance and pay premium accordingly.

3

Constructive in the sense that there is an implied obligation to invest linked funds in line with the statedinvestment policy.

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Term Insurance
30. These products provide life cover over a specified term but usually do not have asurrender value. Insurers should exercise judgement in determining whether these products
are to be included in ALM modelling. Generally, ALM modelling is required for longer terms
where policy liabilities are relatively large.
Accident and Sickness Insurance
31. Like term business, long term accident and sickness liabilities, such as disabled lives
reserves or long-term care, may require some type of ALM modelling.
Non-Life Insurance
32. Although many non-life insurance products have short term liabilities where liquidity is the
major ALM consideration, there are instances where the selection of appropriate supporting
assets is important. These include long tail business where claims reserves are established
to cover liabilities that may emerge or will be finalised several years in the future and may besignificantly increased by claims inflation during that time, and structured settlements, where
similar considerations to annuity business will apply. The selection of appropriate supporting
assets is also important for blocks of business in run-off where there will be no continuing
premiums to provide liquidity to meet claims as they arise. Lingering court cases can creatematerial uncertainty for some insurers about the level of claims that will have to be paid andlead to a shortening of the term of the insurer’s investments to guard against liquidity risk.

4. ALM Measurement Techniques
33. This section introduces some of the basic measurement techniques and how they can beused for ALM.
Duration and Convexity
34. Duration and convexity are important measures of interest rate risk for fixed income
securities and interest bearing liabilities. Duration is a measure for the sensitivity of the valueof an asset to changes in interest rates. Duration is a simplistic measure and should be usedwith care. Convexity measures the rate of change of the duration with respect to the interest
rate. This means that it is a measure of how sensitive an instrument’s duration is to changes
in the interest rate (i.e., it shows the curvature of the price profile of the instrument). It is
important to note that both concepts only apply to small parallel rate changes in the yield
curve but not to twists or bends in interest rates. Measures include: Macaulay duration,
modified duration, effective duration and money duration (refer to the Appendix for definitionsof these terms).
35. Duration measures only interest rate risk within one currency, so that it cannot be
aggregated across multiple currencies. Also duration cannot be used to capture large factor
changes.
36. In duration matching, duration and convexity measures are used to immunise a portfolioof assets and liabilities from fluctuations in interest rates. In other words, the surplus of theportfolio (assets minus liabilities) as a proportion of total assets will be unaffected when theinterest rate changes.

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37. For immunisation of a portfolio, three criteria must be met:•••

the present value of the assets must equal the present value of liabilities
the duration of assets and liabilities must be equal
the convexity of the assets must be greater than that of the liabilities.

38. Because the duration of assets and liabilities can drift apart when interest rates change,
durations have to be monitored continually. It is often quite difficult to calculate the durationor convexity of assets and liabilities depending on the assets held and the types of policies
written.
Value at Risk (VaR) and Tail Value at Risk (Tail VaR)
39. VaR measures, often used in banks, provide a probability-based boundary on likely
losses for a specified holding period (e.g., 10 days to 1 year) and confidence level. The
holding period typically represents the length of time until a company can defease or exit theposition/situation that caused the risk. Tail VaR (also known as Conditional Tail Expectation CTE) may be preferred to VaR for measuring catastrophe risks and other low frequency highseverity risks and risks extending over a long time period. However, quantile measures such
as VaR and Tail VaR have a limited ability to accurately capture what happens in exceptional
circumstances or extreme events. This is because statistical inference is imprecise without asufficient number of observations and, in any event, it is based on extrapolation of pastexperience, which is not necessarily representative of systemic risk.
Liquidity ratio
40. Insurers need to estimate the normal expected amount of liquidity that would be required
to meet the demands of their underlying liability portfolios for various time horizons. They canthen establish a ratio by taking this amount and adding a margin to cover unexpected liquidity
requirements. The liquidity ratio is usually included in the insurer’s investment policies.
Cash flow management
41. The aim of this ALM technique is to compare the cash flows of the liabilities with the cash
flows of the assets and measure the effect of changes in interest rates, including parallel
shifts, twists and bends. Options to adjust cash flows to produce the desired risk profile arethen considered.
42. The size and timing of cash flows might be difficult to forecast, however; for example, inthe case of a large claim for non-life insurance or with embedded options for life insurance. In
addition, an insurer may have difficulty finding assets with the properties needed for cash
flow matching. For example, it might find an asset with the desired maturity but the issuer
might not meet the insurer’s investment standards.
43. The level of precision in cash flow matching is dictated by the cash flow certainty of theliability and the organisation’s total return objective and risk tolerance level. Organisations
with high total return objectives and higher risk tolerances would accept a lower level of cash
flow matching in order to achieve their rate of return goal.

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Deterministic scenario testing
44. To manage uncertain future cash flows, ALM requires the use of models. Deterministic
models project business results into the future based on a small number of sets of cash
flows. The results obtained are valid for these specific scenarios. Deterministic scenario
testing may be sufficient where the scenarios are representative of the type of businessbeing considered and can support reliable ALM decisions.
45. More complex models, such as stochastic scenario testing, are needed if future cash
flows depend on future economic conditions.
Stochastic scenario testing
46. To estimate future expected cash flows under various scenarios, stochastic models
based on simulations are used. Using these techniques it is also possible to construct many
possible scenarios and arrive at statistical distributions of the results. The results measurerisk exposures in the portfolio of an insurer. By studying the range of results, the insurer canevaluate different ALM strategies.
47. In general the five components of a model are:
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•
•
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set of assumptions
stochastic scenario generator
financial calculator
optimizer
output.

48. The set of assumptions includes general economic assumptions such as changes ininterest and foreign exchange rates, changes in liquidity conditions, economic shifts andpossible market events. It may also include assumptions related to the business of theinsurer such as premium levels and the impact of management responses and controls
related to modelled asset movements (e.g., stated bonus/dividend philosophy). Particularattention must be given to the relevance and reliability of the assumptions.
49. The stochastic scenario generator develops scenarios based on the assumptions madewhich are then transformed by the financial calculator into financial results, which are
selected and assessed by the optimizer before the output is produced.
50. Stochastic models apply stochastic processes that are run simultaneously for assets andliabilities. These models are useful for product design as they allow the insurer to examine
the impact on its financial position of various new products under simulated market
conditions.
51. Stochastic models have their limitations. The underlying probability distributions must be
carefully selected. It may also be appropriate to test the dependence of the results on the tailof the distribution where the model may least faithfully represent reality. This may, forexample, be achieved by flexing the size and the shape of the tail of the distribution being
used. Other potential difficulties are the calibration and validation of models and theinterpretation of their output.

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Stress tests
52. Stress tests assist insurers in managing risks and maintaining adequate financial
resources to deal with those risks. These are discussed in detail in the IAIS Guidance paperon stress testing by insurers (2003). Stress tests can be used to identify and quantify theoverall impact of different stress scenarios on an insurer’s future financial position. They do
not predict what will happen, but are useful for examining what might happen.
53. Stress testing encompasses both sensitivity testing and scenario testing. Sensitivity
testing examines the effect of changing one or a few variables rather than considering a fullalternative scenario. The scenario testing used as part of stress testing may go beyond
deterministic scenario testing. Stress test scenarios may, for example, include modelling withreference to historical events and to risk databases.
54. Stress tests should be appropriate to the insurer’s own risk profile and the businessundertaken. For example, stress tests should reflect the fact that insurers do not allunderwrite the same classes of risks, accept the same level of risks, have the same
distribution systems, employ the same reinsurance arrangements, have the same distributionof assets by investment type/grade or have the same operational systems and controls.
55. To truly test the insurer’s exposure to ALM risk, stress testing should address significant
adverse threats to the future financial condition of the insurer, rather than just mildly
uncomfortable possibilities.
56. In addition, the insurer should use stress testing for assessing capital requirements,
strategic planning and for contingency planning. The board of directors and management
need to know how adverse a risk must be for it to impair the insurer’s financial position. Thisshould include all risks arising from the insurer’s assets and liabilities, including market risk,
underwriting risk and liquidity risk.
57. For insurers, market risk is the extent to which an adverse movement in the value of theassets as a consequence of market movements, such as changes in interest rates, foreignexchange rates, equity prices, etc., is not offset by a corresponding movement in the value ofthe liabilities. Examples of market risk related scenarios to consider when undertaking stresstests are:
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the possibility of a severe economic or market downturn leading to interest rate
movements that adversely affect the insurer’s financial position
the impact of price shifts in asset classes on the entire portfolio
inadequate valuation of assets such as real estate and derivatives that are not effected
or issued on or under the rules of a regulated market
the direct impact on the portfolio of currency devaluation, as well as the effect on
related markets and currencies
the extent of any mismatch of assets and liabilities, including reinvestment risk
the impact on the portfolio value of a dramatic change in the spread between a market
index of interest rates and the risk free interest rate
the extent to which market moves are non-linear between sectors and could have nonlinear effects on values, e.g., derivatives
the effect of credit rating downgrades and variations in market credit spreads on thevalue of assets
the impact of interest rate changes on the potential exercise by policyholders of options
under their contracts.

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58. Liquidity risk relates to the possibility that an insurer will be unable to realise the assets it
needs in order to fund its obligations as and when they fall due without incurring losses.
Understanding whether an insurer’s cash flow is sufficient to meet its commitments topolicyholders and other creditors is fundamental. Factors to consider when undertaking
stress tests include, but are not limited to:
•
•
•
•
•

any mismatch between expected asset and liability cash flows
the inability to sell assets quickly (at a fair and reasonable price)
the extent to which the insurer’s assets have been pledged
the cash-flow positions generally of the insurer and its ability to withstand sharp,
unexpected outflows of funds via payment of claims, or an unexpected drop in the
inflow of premiums
the possible need to reduce large asset positions at different levels of market liquidity,
and the related potential costs and timing constraints.

5. Methods of managing asset-liability mismatches
59. This section describes a number of additional considerations and approaches that areimportant for ALM by an insurer. Risks an insurer assumes, and to which it is exposed, arecontinuously changing. Internal risk factors arise from the financial objectives, risk tolerances,and constraints of the insurer. External risk factors may include: general economic activity,interest rates, equity returns, competition, the legal environment, regulatory requirements,
and tax constraints. Such factors may impact both assets and liabilities simultaneously,
although the impact is not necessarily of the same magnitude or in the same direction in aparticular time period or over a period of several years. This dynamic environment, which isalso effected by random factors, creates uncertainties in the future cash flows and balance
sheet values and in the true risk exposure of the insurer. The risks an insurer faces will varyas the underlying risk factors change and as future cash flows are replaced by actual cash
flows.
60. An insurer has several options for managing the risks associated with assets andliabilities (and the interaction between them). These include bearing the risk, hedging,reinsurance and product management. The method used will depend on the insurer’s
objectives and risk tolerance along with the effectiveness, relative costs and availability of theoptions and the relationships with the counterparties involved. At times, the capacity of themarket to absorb certain types of risk (e.g., long term reinvestment risk) may be limited.
Hedging
61. Hedging can play an integral role in the ALM process. It is the technique of designing aportfolio with cash flows that can be used to offset another portfolio's cash flows in certain
scenarios. The insurer still retains the original risk, but the hedging results in a net reductionof overall risk. Hedging instruments include assets, liabilities, and derivatives (e.g., options,futures, swaps, forwards, swaptions, and exotics). An asset with expected cash flows
matching those expected for a liability is a simple hedge.
Hedging is distinct from diversification, i.e., the technique of combining exposures that areless than 100% correlated to reduce overall risk. Hedging is a strategy available to reduce
systemic risk or non-diversifiable risk.

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62. Hedging is often used:••

to reduce systemic or non-diversifiable risk4
for insurance products with options and/or guarantees.

63. Hedging should be carried out in the context of an appropriate risk management policy
approved by the board of directors. Relevant procedures5, management information andreporting, and systems and controls should be in place. After hedging, the risk profile shouldbe aligned with the board of directors’ risk tolerances. Insurers must regularly reassess theirreliance on and the effectiveness of hedging and diversification and rebalance portfolios
when necessary. The time horizon over which the hedge is in place may vary, but should be
explicitly defined.
64. Hedging opportunities depend on what is available in the market. It may be possible, forexample, to arrange specialised tailor-made over-the-counter (OTC) packages throughinvestment banks. Some jurisdictions may not have access to hedging opportunities locallyand it may therefore be necessary to seek hedging opportunities in other countries. Hedging
methods are either static or dynamic:
Hedging
methodAdvantages

Disadvantages

Static hedging

Less skill requiredHigh fees to counterparties(uses fixed andunchanging
hedges)Dynamic hedging

Requires frequent reviews andadjustments

Efficient in terms of managing therisks and rewards(rebalanceshedge positions
as market
conditions
change)Requires a test period to ensure
staff and systems are ready andable to respondHigh operational risk, basis risk,
frictional costs and the risk that, involatile and illiquid markets,hedging in line with the model may
not be possible

65. Hedging reduces some risks but may introduce other risks, such as:•credit risk from exposure to counterparty default

4

For example, when a stock market decline results in guarantees under equity-linked contracts being in themoney for many contracts at the same time.

5

For example, the successful operation of a derivatives program is likely to require the use of internal models.

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•
•
•
•

credit risk of the underlying instrument
basis risk from imperfect or partial hedging, where the hedging instruments are not
perfectly negatively correlated with the risks being hedged. In some instances, anincomplete hedge may even increase the overall risk.
market risk, especially non-linear or geared market risk, through the use of derivatives
liquidity risk due to requirements to provide collateral on derivative transactions.

66. The supervisor should review the insurer's hedging programme6, the availability ofnecessary financial instruments, the experience and abilities of personnel engaged in thissophisticated activity and the insurer’s ability and success in conducting the hedging
programme.
67. Supervisors may need to put in place regulatory disincentives (e.g., additional capitalrequirements) to guard against the hedging programme going beyond what is required for
effective hedging (for example, where the programme significantly increases exposure tomarket risk) and to instil discipline in the financial modelling used by the insurer.
Reinsurance
68. Reinsurance is a method of passing a risk to another insurer and hence can be used tomitigate ALM risk. It is used primarily to manage liability risk, but may also be used to resolve
some ALM risks. For example, one alternative to holding assets in order to match equitylinked liabilities would be for the insurer to enter into an equity-linked reinsurance contract.
69. In the context of ALM, reinsurance may also be arranged to:••••compress, truncate or smooth the volatility of the insurer’s projected cash flow profile,enabling better matching of assets to the remaining cash flows
transfer investment risk
share expertise with the reinsurertransfer risk to the capital markets through securitisation.

70. While reinsurance normally transfers away some risks, it introduces counterparty andconcentration risk. Counterparty risk occurs if the reinsurer cannot fulfil its obligations to theinsurer or if the reinsurer’s creditworthiness deteriorates. Factors that lead to counterparty
default by reinsurers may be highly correlated with the factors that would lead the insurer
itself into financial difficulty. Insurers should monitor the creditworthiness of their reinsurers
on an ongoing basis, but particularly when the reinsurer is based in a different country or isless well regulated than direct insurers.
71. Counterparty risk may be reduced by collateral requirements or rating triggers in thereinsurance contract whereby, for example, the reinsurer is required to post collateral if its
external credit rating falls below a particular level. This may lead to a significant drain on thereinsurer’s liquidity and may need active management in the ALM process.
72. Reinsurance can also give rise to concentration risk, for example:

6

This applies to derivatives used for existing and new insurance business.

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•••a diverse asset portfolio may be replaced with a single reinsurance asset (albeit thatthe reinsurer may hold a diverse portfolio itself)
reinsurance with insurers in the same corporate group may obscure the level of risk
within the groupan insurer may have exposures to a particular reinsurer or its group companies, otherthan those arising from reinsurance itself.

Matching across asset-liability segments
73. An additional approach to ALM is to identify separate homogeneous segments ofliabilities and obtain matching investments appropriate to each segment, which would beappropriate if each liability segment was a stand-alone business. However, this strategy
could be suboptimal ALM, as it ignores the opportunities for profit and management of riskthat can be gained from treating the business as a whole within the insurer.
74. There are some types of insurance business for which, to protect policyholders, it isappropriate for assets and liabilities to be ring-fenced, or for liabilities to be closely matchedwith corresponding assets. For example: i) non-life insurance business is normally ringfenced from life insurance business; ii) a separate fund of assets may be used to determine
the benefits under with-profits business; iii) equity-linked or indexed-linked benefits may beclosely matched with corresponding assets; and iv) annuities cash outflows may be matchedwith cash inflows from fixed income instruments.
75. Although ALM can be practised for each business segment within the insurer separately,
this is likely to mean that the benefits of scale, hedging, diversification, and reinsurance thatcan be gained from managing the different segments of assets and liabilities together are
ignored or receive less attention. This may apply to assets and liabilities managed within a
corporate group by different management teams. When the insurer is part of a corporategroup, there may therefore be benefits to be gained from coordinating ALM across a
corporate group or applying it as a centralised function, subject to restrictions on movementof funds across legal entities. This may possibly be achieved using notional segment asset
portfolios to help distinguish between the performances of different management teams.
Operational risk that the coordination may be inadequate may arise from this less specificapproach to ALM.
Long duration liabilities
76. Some liabilities may have particularly long durations, such as product liability and wholelife policies and annuities. There may be a significant reinvestment risk, such that the present
value of future net liability cash flows is particularly sensitive to changes in interest rates.
77. Many markets throughout the world do not have long fixed-income assets to back long
duration liabilities. There may also be gaps in the asset durations available. This may be anissue even in the most well developed markets for some types of liabilities. Possible ways ofaddressing this may include:••

using derivatives to align the sensitivity of the assets with the likely movements in thevalue of liabilities
designing products that share the risk with the policyholder and/or provide low
monetary guarantees.

78. Because of the difficulty of matching the long-term liabilities, it may be appropriate for the
insurer to separate the long term ALM portion of the tail liability from that of the shorter term
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assets and liabilities. This can help to ensure that adequate focus is maintained on the longterm risk and that action is taken early enough to anticipate problems that may only emerge
many years into the future (for instance, with annuity guarantees). Long tailed liabilities
should be the subject of specific supervisory focus to ensure that ALM risks are identified andproperly managed.

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Appendix- Definitions
Throughout this paper and the ALM Standards paper a number of definitions and key words
are used. Some of the key terms are defined here; for more general insurance terminology
refer to the IAIS Glossary of terms.
1.
Accumulation annuity: a contract that accumulates, with interest, either a single
premium or a series of premiums and which provides a maturity benefit at some point in the
future or provides an option to convert to a payout annuity.
2.
Asset-liability management: the practice of managing a business so that decisions
and actions taken with respect to assets and liabilities are coordinated. ALM can be definedas the ongoing process of formulating, implementing, monitoring and revising strategies
related to assets and liabilities to achieve an organisation’s financial objectives, given theorganisation’s risk tolerances and other constraints. ALM is relevant to, and critical for, thesound management of the finances of any organisation that invests to meet its future cash
flow needs and capital requirements. (Source: Society of Actuaries, Specialty Guide on ALM(2003))
3.
Asset-liability risk (ALM risk): the risk addressed by asset-liability management. ALM
risk (sometimes referred to as mismatch risk) is the risk that the cash flows arising from theassets supporting the liabilities do not match the liability cash flows.
4.
Convexity: an important measure of interest rate risk (together with duration) for fixedincome securities and interest bearing liabilities. It measures the rate of change of theduration with respect to the interest rate. This means that it is a measure of how sensitive an
instrument’s duration is to changes in the interest rate i.e., it shows the curvature of the priceprofile of the instrument.
5.
Deferred accumulation annuity: an annuity providing for payments to begin at somefuture date. (Source: Canadian Life & Health Insurance Association, Glossary of Insurance
Terms (2006).
6.
Duration: is an important measure of interest rate risk (together with convexity). It is ameasure for the sensitivity of the value of an asset to changes in interest rates.

7.
Economic value: the value of asset or liability cash flows, derived in such a way as tobe consistent with current market prices where they are available, or using market-consistentprinciples, methodologies and parameters. (Source: Comité Européen des Assurances –Groupe Consultatif Actuariel Européen, Solvency II Glossary (Draft April 2006))
8.

Effective duration: is defined as the approximation

D ≈ (-1/P) ((P+-P-)/(r+ –r-))where P is the price of the instrument before any parametric shift. In the case of interest rates thisrepresents the unshifted yield curve. r+ represents a parallel up shift whereas r- represents a parallel

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down shift. P+ represents the value for the positive shifted scenario r+ and P- the value for thenegative shifted r-. This concept is very sensitive to the size of the shift of the yield curve.

9.

Exotic contract: an investment contract with a new or complex structure

10. Forward (or Forward contract): a contract for the delivery of a particular commodity
or financial product in the future in exchange for a contract-specified price. A commitment tobuy (sell) an asset at a future date for a price determined at the time of commitment, usuallyreflecting the net cost of carry.
11. Future: a standardised forward contract offered by a central trading exchange (such as
the New York Mercantile Exchange, or NYMEX).
12. Immediate payout annuity: an annuity contract that provides an income on an
immediate basis, as distinct from a deferred annuity.
13. Lifetime annuity: same as a life annuity, defined in the IAIS Glossary as a contractthat provides income for the life of the annuitant.

14. Macaulay duration: The duration for any bond with cash flow payments of C1…Cn attimes t1…tn and interest rate r is defined as:nD=∑ C (1 + r ) t
i =1
n

−ti

i

∑ C (1 + r )

−ti

i

i =1

15.

i

Modified duration: is expressed as:
n

1
MD =
1+ r

∑ C (1 + r )
i =1
n

− ti

i

∑ C (1 + r )
i =1

ti

− ti

i

16. Money duration: measures the absolute sensitivity of an investment’s position in thelocal currency. For fixed income instruments it can be expressed as:
Duration = Delta * Market Value, where delta is the change in interest rates.
This measure can be useful when the economic values of assets and liabilities differ.
17. Monte Carlo simulation: a method that estimates possible outcomes from a set of
random variables by simulating a process a large number of times and observing theoutcomes.

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18. Option: the contractual right, but not the obligation, to buy or sell a specified amount ofa given financial instrument at a fixed price before or at a designated future date. A call
option involves the right to buy the financial instrument. A put option involves the right to sell
the financial instrument.
19. Payout annuity: a contract that provides income to a policyholder for a specified
period of time, such as a number of years or for life.
20. Surplus ratio: the ratio of the insurer’s capital available to its capital requirements as
defined by the solvency regime within the insurer’s jurisdiction.
21. Swap: a financial transaction in which two counterparties agree to exchange streamsof payments over time according to a predetermined rule. The most common form of swap is
a “vanilla” interest rate swap. With that structure, one party pays interest at a fixed rate while
the other pays according to a floating rate such as LIBOR.
22.

Swaption: an option on a swap.

23. Tail Value at Risk (TVaR or Tail VaR): is the quantile value at risk (VaR) plus theaverage exceedence of that quantile if such exceedence occurs. (Source: International
Actuarial Association, A Global Framework for Insurer Solvency Assessment (2004))
24. Underwriting risk: is the specific insurance risk arising from the underwriting of
insurance contracts. The risks within the underwriting risk category are associated with boththe perils covered by the specific line of insurance (including reserving risk) and with thespecific processes associated with the conduct of the insurance business. (Source:International Actuarial Association, A Global Framework for Insurer Solvency Assessment(2004))
25. Unit-linked policy: is a life insurance contract which guarantees a link between
policyholder funds and external equity or bond indices or market values.
26. Universal life policy: is a combination flexible premium, adjustable life insurance
policy. The policyholder may select the amount of premium to pay and the policy benefits arethose which the premium will purchase. If the policyholder may choose to pay a premium thatis greater than that required to support the chosen benefit, the excess accumulates as aninvestment.
27. Value at Risk (VaR): a measure of the potential financial loss in the investment
portfolio or on the whole balance sheet. Value at risk provides an estimate of the worst
expected loss over a certain period of time at a given confidence level. For example, a 12month value at risk with a 95% confidence level of $1 million means that an insurer would
only expect to lose more than $1 million 5% of the time or once in 20 years. [Source:
Investments Subcommittee Guidance paper on investment risk management – October
2004]
28. Variable annuity: an annuity contract under which the amount of each periodic
payment fluctuates according to the investment performance of the block of assets backing
the annuity portfolio that is held by the insurer.

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