Fap3-4

Module 3: Risk in Actuarial Problems

Section 4: Risk Management for Financial Security Systems

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Objectives

• Determine factors or influences that are important to identify and analyze risks.
• Use techniques commonly used in asset-liability management (ALM) with financial security systems.
• Describe the various risk measures that are used in ALM.
• Describe the capital requirements for a financial security system.
• Describe the role of risk measurement tools when analyzing the risks in financial and non-financial organizations.
• During this section, you will read Risk Measures for Asset Liability Management in Life Insurance Companies as a foundation for understanding ALM throughout this course. You will look at financial markets through the capital asset pricing model and review the need for capital under a financial security system. You will also consider how non-financial corporations often manage risk.

Financial Security Systems

• In Investment Science (1998), Luenberger states:
  “Investment science guides us in the process of combining stocks, bonds, and other investment products into an overall package that has desirable properties.” (p. 3)

• Section 4 continues to look at ALM problems associated with financial security systems and introduces some of the mathematical tools needed to work with cash flows in an ALM problem. You will examine some financial economics examples since these concepts will be needed in the asset liability exercises introduced in this section, in the balance of Module 3, and in Modules 4 through 8. Recall the ALM portion of the financial security system graphic by clicking and reviewing the graphic (middle pillar).
• Section 11.4 in Understanding Actuarial Practice (2012) reviews asset-liability management (ALM) in the life insurance industry. It provides an overview and comparison of the types of risk measures, the history of ALM, and a glimpse at the future. Some of the risk measures introduced in the article will be used in the exercises introduced later in this section. Note how risk measures have changed over time with the emphasis originally placed on point estimates—with little to no attention paid to the connection between assets and liabilities—to the current emphasis of managing assets and liabilities together.
• In the 1990s insurers introduced variable life/annuity products where some risks were passed to the policyholder. Guaranteed Minimum Death Benefit (GMDB), Guaranteed Minimum Maturity Benefit (GMMB), and Guaranteed Minimum Income Benefit (GMIB) features were added to enhance the competitiveness of these variable products against other investment products.
• Dynamic Modeling is a type of risk measure that incorporates "potential reactions to the outcomes of each scenario".
• In the second half of the 1980s, high profile financial failures of several life insurers were the result of inadequate management of increased investment and asset/liability risks. This led to increased ALM practices, but also government regulation.
• Spread is a point estimate that measures the excess of the asset portfolio yield over the liability portfolio yield. It's a risk measure that was implemented in life insurance in the 1970s.
• In the 1980s, new product development in the life insurance industry shifted from mortality/morbidity risk to investment orientation.
• The present value of a stream of cash flows is an example of point estimates, which are snapshot statistics and metrics calculated at a point of time.
• The weaknesses of stochastic modeling include
  • Complex and less tractable
  • Requires numerous assumptions

• Modified duration and effective duration, both capture exposure to changes in the level of interest rates, but ignore changes in the slope of the yield curve. So the key rate duration (KRD) calculation, which involves shifting a specific point (i.e., a key rate) on the yield curve while the rest of the yield curve remains constant, was developed.

Deterministic Cash Flow Streams

• Read Chapter 6 in Understanding Actuarial Practice (2012). Once finished, complete exercises 6.1 and 6.2 from Section 6.5.
• The following activities, based on Chapter 6 of Understanding Actuarial Practice, involve the pricing of annuities and bonds.
  • m3s4_activity_a_01_Chapter_6.pdf.
  • m3s4_activity_a_02_Annuity_Pricing.xls.
  • m3s4_activity_a_03_Annuity_Pricing_Solution.xls.
  • m3s4_activity_a_04_Bond_Pricing.xls.
  • m3s4_activity_a_05_Bond_Pricing_Solution.xls.
• Now read Chapter 7 and Sections 11.1-11.3 of Understanding Actuarial Practice (2012). Chapter 7 provides an overview of asset types. Sections 11.1, 11.2 and 11.3 are used for problems associated with financial security systems. Once finished, complete the exercises exercises 11.1 and 11.2 from Section 11.5. Solutions can be found in the online materials that accompany the text.
• If the duration of the asset cash flows equals the duration of the liability cash flows then the portfolio must be immunized to the extent provided by duration matching, but only after having balanced the underlying present values of the asset and liability cash flows. Immunization by duration matching also requires that the initial present values of the cash flows are also equal.
• Immunization is an approximate process. Duration matching simply tells you that the present values of the asset and liability streams react the same way to changes in the yield. Duration matching is based on the assumption that yields on all bonds are equal and, when they change, will change by the same amount. This is clearly not the case. Convexity improves immunization as asset and liability streams with the same present value, duration, and convexity provide an even closer match. As yields change, however, durations will have to be recalculated and portfolios may have to be rebalanced. In other words, matching duration in a portfolio lowers the risk that your portfolio will become materially unbalanced through a change in yield. Balancing both the duration and convexity reduces the risk further. The risk, however, is not reduced to zero (i.e., eliminated).
• The following activities, based on Chapter 11 of Understanding Actuarial Practice, look at the sensitivity of price to changes in interest rates. Download each of the following files. The first file, m3s4_activity_b_01_Chapter_11.pdf, provides directions on when to use each of the other files.
  • m3s4_activity_b_01_Chapter_11.pdf.
  • m3s4_activity_b_02_Duration.xls.
  • m3s4_activity_b_03_Duration_Solution.xls.
  • m3s4_activity_b_04_Immunization.xls.
  • m3s4_activity_b_05_Immunization_Solution.xls.
  • m3s4_activity_b_06_Convexity.xls.
  • m3s4_activity_b_07_Convexity_Solution.xls.
  • m3s4_activity_b_08_Duration_of_Liabilities.xls.
  • m3s4_activity_b_09_Duration_of_Liabilities_Solution.xls.
• Read Chapter 10 in Understanding Actuarial Practice (2012). After the reading, complete the exercises in Section 10.3: Exercises 10.1 and 10.2. Solutions can be found in the online materials that accompany the text.
• Read Chapter 11 in Understanding Actuarial Practice (2012), which discusses risks that are unique to financial security systems, which are often related to the need for capital. The financial security system must establish the assets necessary to meet its obligations to its beneficiaries.
• Economic capital is defined as the amount of capital that the firm needs to support its operations, given its risk profile. Stating the risk profile as a probability of remaining solvent is a special case. It is important to note that economic capital is different from regulatory capital, which is normally set by the prudential regulator, who is concerned about the solvency and long-term sustainability of the entity.
• Regarding the need for capital:
  • All businesses need capital. The level and type of capital should be related to the risk appetite and strategy set by the board. There is a natural tension about the level of capital between the various stakeholders.
  • There is no “correct” balance between debt and equity in an organization’s capital structure.
  • Economic capital represents an important measure to assess a company’s risk-adjusted performance.
  • Economic capital and regulatory capital are not the same and serve two different purposes.
  • In addition, the level of risks accepted by the company must influence its level of capital. These risks include those related to assets, liabilities, the asset-liability relationship and operations. The allocation of capital between separate businesses within an organization represents an important management tool. The allocation of the capital saving arising from the diversification of risks across an organization is not straightforward and can be carried out in several ways.
• The risks associated with the need for capital are summarized in Section 11.5 of Understanding Actuarial Management 2010.
• Summary for the need for capital: The risks summarized under the need for capital can be found in the financial security system graphic as follows:
  • Under asset risks, the authors list default risks and market movement risks. These are clearly set out in the graphic.
  • The authors also listed asset concentration as a risk. This risk is managed in a financial security system through asset selection and in portfolio management.
  • The other asset risks are not common to all financial security systems.
  • Pricing risk is set out as a liability risk. It is a prominent strategic risk on the liability side of the financial security system graphic.
  • Under liability risks the authors also listed valuation of liabilities as a risk. These risks are included under reserves and capital management on the financial security system graphic.
  • Experience is also listed as a risk that is covered under hazard risks, volatility and severity of claims on the financial security system graphic.
  • Concentration of liabilities is properly managed, in part, through the selection of risk function. Management of potential significant unexpected events is of course part of the overall enterprise risk management for a financial security system.

Landfill case study

• The "landfill" study case considers the life cycle of a landfill site and demonstrates how long-term liabilities such as closure and post-closure maintenance costs may be managed. There is a “need for capital” in the generic sense associated with the landfill site. The Landfill Case Study was developed to illustrate how actuarial concepts and principles may be applied to nontraditional actuarial problems.
• The Landfill Case Study begins in Module 3 and continues in Module 4. The Module 3 portion of the case study emphasizes the process of identifying risks and completing the Define the Problem stage of the Control Cycle. This includes reviewing external forces that are associated with the problem. The case study also provides an overview of the pricing principles that should be applied to the valuation of the landfill site’s closure and post-closure costs. You will also review the issues surrounding a second problem, funding the closure and post-closure costs in advance.
• The second part of the Landfill Case Study, covered in Module 4, emphasizes the Design the Solution stage of the Control Cycle given the problems defined in Module 3. You will be introduced to a funding method, the Aggregate Method, as part of the solution. The Aggregate Method is based on a collective actuarial model that has been used by actuaries providing funding services to defined benefit pension plans. (Note that collective actuarial models are reviewed in Section 5 of Module 3.)
• Communication of results is extremely important in actuarial work, especially if your solution is not “typical” or already familiar to your audience. As part of the case study, the results of your work on the Landfill Case Study must be clearly communicated to the users of the work. Part of this case study work will form the basis of a report that you will work with in Module 4.

Non-Financial Security System Risk Management

• Review Chapter 20 (Sweeting_Ch20.pdf) of Sweeting.
• Sweeting argues that the loss of a space shuttle has implications for financial institutions. Specifically, managers must understand the risks. They cannot rely on subordinate managers. Nor can they ignore warnings that conflict with their objectives to increase profits.

Summary

In this section you looked more closely at the relationship between analyzing risk and defining the problem. You examined case studies and looked at readings on asset-liability management (ALM). Each step you take to correctly define the problem brings you one step closer to achieving an optimal solution.