Asset-liability management enables re/insurers to gauge their risk appetite.

The recent decline in the investment markets has pushed the asset management side of the re/insurance company equation into the spotlight. After years of soft market, in which investment returns helped balance out losses in the underwriting book (though not always successfully), the drop in investment portfolio performance has further pushed companies to focus on underwriting discipline. Nevertheless, asset management is an increasingly important part of corporate strategy, particularly after the buffeting some re/insurers have received in defaults on corporate bonds.

In its most recent annual survey of insurance asset managers, WorldTrade Executive identified $248bn under the control of insurance asset managers, an increase of 14% on the previous year. Of the 31 asset managers that participated in the survey, Deutsche Asset Management came in the top slot, reporting $34.3bn insurance assets under management at the end of last year. Second place went to Blackrock, with $30.6bn under management, while Conning Asset Management Co came in third, with $27.6bn of unaffiliated insurance assets under management.

In summer 2001, Conning became part of Swiss Re, complementing the Fox-Pitt, Kelton investment bank arm of the re/insurance giant. Even so, Swiss Re continues to manage its own investments, and recently has opened up its expertise to other re/insurers in its London-based Swiss Re Asset Management Ltd. "We have managed our own assets since 1863," said client relationship manager, Tony Maximchuck. This history lends Swiss Re the ability to take an holistic view of the insurance entity, he said, understanding the interaction between assets, liability and the economy. "We also use it for the reinsurance strategy and capital allocation," he added.

Asset-liability management - the careful co-ordination of assets and liabilities - is still a relatively new field for the re/insurance sector. Developed to address interest rate risk, asset-liability management (ALM) has been around since the 1970s. According to the Society of Actuaries, ALM is defined as "the practice of managing a business so that decisions on assets and liabilities are coordinated; it can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints ... ALM is relevant to, and critical for, the sound management of the finances of any institution that invests to meet liabilities."

Originally developed in the life insurance sector and thus typically looking at single lines of business, ALM has been increasingly adopted by non-life companies with more complex risk portfolios and refined into `dynamic financial analysis' (DFA).

In a sigma report published in 2000, Swiss Re predicted that the use of ALM was likely to increase in the insurance industry. "This is due to several factors," it stated. "On the demand side, these include the increasing complexity of insurance companies, the concerns of regulators and ratings agencies, and the activity of internal risk management committees. Major supply side factors include improvements in computer technology and the involvement of professional actuarial organisations, which support a trend towards more sophisticated modeling techniques."

In addition, ALM is a handy risk management tool for insurers, according to the sigma report. "Controlling interest rate risk, the original purpose for which ALM was developed, is no trivial task," it stated. "If it were, there would be fewer examples of companies that experienced financial distress of insolvency following a large swing in interest rates. While techniques such as duration matching are extremely useful for managing interest rate risk, ALM helps insurers manage other types of risk as well. ALM techniques such as DFA promote improved decision-making and help senior managers understand the impact of their actions from multiple perspectives. To cite but a few examples, ALM can guide insurers in how they allocate assets, select reinsurance, and design products."

There were problems, however, identified in the report. Most importantly, ALM lacked standardisation so different organisations meant different things with the same terms, it pointed out. "Additionally, the complexity and range of choices that each modeling exercise entails make it difficult to compare results from different analyses. This limits how useful model output will be to outside parties such as ratings agencies."

The emergence of larger insurers has pushed forward the demand for ALM, commented the sigma report, accelerated by financial services M&A activity in the wake of deregulation. In addition, it saw high profile events such as insurance company failure as catalysts for the ever-increasing use of ALM techniques. "Following these events, insurance regulators and ratings agencies feel pressure to intensify their industry oversight, increasing the demand for ALM techniques," it stated.

One of the most important facets of implementing an ALM process is setting the strategy, said Swiss Re Asset Management's ALM manager, Brian White. "The two big levers are the underwriting and investment side," he explained. "They don't operate independently," and therefore the corporate strategy must look at a wide range of outcomes.

"We show the clients the implications of a variety of different strategies, making it more transparent for them what various decisions mean," added Mr Maximchuck.

Swiss Re's `Financial Integrated Risk Management' (FIRM) process is used to evaluate the impact of different asset strategies, and can also incorporate a number of factors including the impact of adding new lines of business, changing the business mix, capital allocation and strategies for new products.

Swiss Re describes the FIRM process as:

  • holistic - it analyses the entire company from all perspectives;

  • quantitative - it uses computer modeling tools to quantify the results and help make informed financial decisions;

  • probabilistic - many scenarios are examined to capture a distribution of risk and reward; and

  • multi-period - its strategic approach provides a prospective view that factors in the uncertainty of future developments.
  • Swiss Re's process of implementing a full asset management strategy passes through several steps before reaching any conclusions.

    The first step is strategic asset allocation, in which the FIRM process is used to evaluate the impact of different strategies. Following this comes tactical asset allocation (TAA).

    This is an adjustment made around the strategic allocation to take advantage of investment opportunities in shorter time periods, and looks across global markets.

    Step three is security selection. Swiss Re runs seven investment centres around the world, and fund managers from these tailor portfolios.

    Finally, the Swiss Re constantly reviews economic developments in order to continually renew the process.

    "Investments are an important part of running the business," commented Mr White. "An insurance company needs a liquid portfolio of high quality," he added, but using ALM methodology can let clients get a better insight into their risk appetite. "It gives extra insight into the cost of compromise."
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  • Sarah Goddard is the editor of Global Reinsurance.

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