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.