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)
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