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Lecture

ACTSC445 Lecture Notes - Interest Rate Risk, General American, Credit Risk


Department
Actuarial Science
Course Code
ACTSC445
Professor
Jiahua Chen

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ACTSC 445: Asset-Liability Management
Department of Statistics and Actuarial Science, University of Waterloo
Unit 1 – Introduction
What is Asset-Liability Management (ALM)?
“ALM can be defined as managing a financial institution so as to earn an adequate return on funds
invested, and to maintain a comfortable surplus of assets beyond liabilities” (from “Quantitative
Risk Management”, by McNeil, Frey and Embrechts)
“ALM is the practice of managing a business so that decisions and actions taken with respect to
assets and liabilities are coordinated. (. . . ) It can be defined as the ongoing process of formulat-
ing, implementing, monitoring and revising strategies related to assets and liabilities to achieve an
organization’s financial objectives, given the organization’s risk tolerances and other constraints.
ALM is relevant to, and critical for, the sound management of the finances of any organization that
invests to meet its future cash flows needs and capital requirements.” (From SOA’s Professional
Actuarial Specialty Guide on ALM)
Why ALM?
Was initially developed to deal with interest rate risk, which became a major concern in the 1970’s, when
rates increased substantially and became quite volatile. For instance, insurance companies often sell
products that are sensitive to interest rates: an obvious example is the option given to the policyowner
to take a loan on the policy at a prespecified interest rate. Before the 1970’s, insurers did not expect
this option to be exercised very often, except under special personal circumstances. However, when
rates went up in the late 1970’s and early 1980’s, several policyowners decide to exercise this option
and invest the loan at a much higher rate than the lending rate. Insurance companies thus needed cash
on a much shorter term than anticipated, and often had to borrow money at a very high price to fulfill
all the loan requests.
Here are a two recent actual examples of what can happen when an insurance company does not
properly manage its assets and liabilities:
In 1997, Nissan Mutual Life, a major insurance company in Japan covering 1.2 million clients
and having about 17 billion US$ in assets, was offering individual annuities at a rate of 5 or
even 5.5%. The company had a significant portion of its assets invested in government bonds,
and when the rates for those dropped to record (low) levels, the wide gap between the promised
return on its liabilities and the one earned on its assets caused the company to go bankrupt (and
was the first japanese insurance company to do so in over 50 years).
In 1999, General American Life in the US had issued for 6.8 billion US$ of short-term funding
agreements at a quite interesting rate, and with the provision that the investors could ask to be
reimbursed within 7 days. When Moody’s downgraded the credit rating of General American
Life from A2 to A3, several investors asked to be reimbursed. In fact, a few days after the
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