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ACTSC 445 (24)

Unit 1 – Introduction

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University of Waterloo
Actuarial Science
Jiahua Chen

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 1 downgrading, a total of 4 billion dollars needed to be reimbursed, which made it impossible for the company to sell its assets quickly enough to satisfy all the reimbursement requests. The company eventually was sold to MetLife. These examples focus on the interest-rate risk, which will be covered in this course, more specifically in the two first parts of the course. But we will also discuss other financial risks. Namely, we will talk about risk measures that can be applied to a portfolio exposed not only to interest rate risk but more generally to market risk. Then we will discuss credit risk, which is becoming an increasingly important issue in financial risk management. Before going over the topics discussed in this course in more details, we give a classification of financial risks that comes from “Quantitative Risk Management”, by McNeil, Frey and Embrechts: Market risk: risk of a change in the value of a financial position due to changes in the value of the underlying components on which that position depends, such as stock and bond prices, exchange rates, commodity prices, etc. Credit risk: the risk of not receiving promised repayments on outstanding investments such as loans and bonds, because of the default of the borrower. Operational risk: the risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events. Underwriting risk (for insurance companies): the risk
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