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Overview of Asset-Liability Management Strategies

Mar 5, 2025

Asset-Liability Management (ALM) Overview

Introduction to ALM

  • Asset-Liability Management (ALM) involves considering both assets and liabilities in investment decision-making.
  • Gained popularity in the 1970s due to interest rate volatility from oil prices and inflation.
  • Previously, asset and liability decisions were independent, causing mismatches.
  • Special cases:
    • Liability-driven investing (LDI): Focuses on managing assets to meet given liabilities (e.g., insurance companies, DB pension funds).
    • Asset-driven liabilities (ADL): Focuses on structuring debt liabilities based on asset characteristics (e.g., leasing companies).

ALM-driven Investors

  • Incorporate both rate-sensitive assets and liabilities into decision-making.
  • Aim to manage market movements and reduce mismatched risk to free up capital.
  • Liability-driven investors: Aim to meet future obligations and maximize surplus given acceptable risk.
  • Asset-only investors: Focus on maximizing returns for a given risk level, ignoring liabilities.

Key ALM Investors

  • Insurance Companies: Manage both assets (premiums) and liabilities (claims).
    • Life Insurance: Deals with long-term liabilities sensitive to interest rates.
    • Non-life Insurance: Covers short-term, uncertain liabilities.
  • Pension Funds:
    • Defined-benefit plans: Sponsors bear investment risk and apply ALM strategies.
    • Defined-contribution plans: Participants bear investment risk.
  • Commercial Banks: Balance short-term liabilities with mid/long assets.
  • Individuals with specific future liabilities (e.g., tuition, retirement).

Understanding Liabilities

  • Liabilities are financial commitments from business and financial decisions.
  • Managing liabilities involves understanding valuation, changing factors, and hedging.
  • Classification based on certainty of cash flows, e.g., Type I (plain-vanilla bonds) to Type IV (complex insurance claims).

ALM Techniques

Cash Flow Matching (CFM)

  • Matches liability payouts with bond cash flows.
  • Requires high-quality bond portfolio matching liabilities schedule.
  • Benefits include reduced risk and passive management.
  • Challenges include perfect implementation and cost concerns.

Duration Matching

  • Hedging strategy to match asset and liability responses to interest rate changes.
  • Considers Duration, Present Value, and Cash Flows Dispersion.
  • Involves levels of sophistication:
    • Basic: Matching durations.
    • Advanced: Considering PV and cash flow dispersion.
  • Benefits include flexibility and cost-efficiency, but risks include reinvestment and liquidity concerns.

Other Techniques

  • Contingent Immunization: Combines immunization with active management.
  • Horizon Matching: Combines cash flow and duration matching for different liability horizons.

ALM/Market Risk Management

Risk Measures

  • Value at Risk (VaR): Calculates expected loss over a holding period.
  • Expected Shortfall (ES): Measures average loss beyond the VaR point.
  • Risk assessment methods:
    • Parametric VaR: Fast but assumes normal distribution.
    • Simulation VaR: Uses market scenarios for portfolios with optionality.

Diversification and Stress Testing

  • Diversification benefits and risks are analyzed through simulations.
  • Stress tests complement VaR/ES by considering tail events and specific scenarios.

Key Interest Rate Metrics

  • Duration and Convexity: Assess value changes due to interest rate shifts.
  • Money Duration: Change in bond price for yield changes.
  • Key Rate Durations: Sensitivity to specific term yield changes.

Accounting vs. Economic View

Accounting/Regulatory ALM

  • Liabilities not typically at fair value; investments partially valued.
  • Regulatory requirements (e.g., Solvency II, Basel III) ensure sufficient assets to cover liabilities.

Economic ALM

  • Values both assets and liabilities at market value.
  • Focuses on Economic Capital (A-L Surplus) as a measure of financial health.

ALM Walk

  • Analyzes changes in surplus over time due to interest rates, credit spreads, market prices, and cash flows.
  • Helps identify sources of change to assist in portfolio management decisions.

Conclusion

  • ALM integrates asset and liability management to align financial strategy with obligations.
  • Various techniques and metrics enhance risk management and financial planning.
  • Understanding investor types and liabilities is essential in applying effective ALM strategies.