CREATING VALUE THROUGH ALM

9 June 2011

Michael Gerstle, Rainer Stragies

Agenda

� Does ALM make sense?

� The liability driven investment process at Munich Re

� Sharing our knowledge via ALPHA

DOES ALM MAKE SENSE?

Does ALM make sense?

� Absence of an appropriate ALM has already led to the insolvency of insurance

companies

� ALM is not a software, ALM is a process!

� Rating agencies tend to reward proper ALM

� Regulators urge insurance companies to do ALM (e.g. through Solvency II), e.g.

the German supervisor BaFin recently issued a new investment circular,

specifying requirements for an obligatory ALM process for life and non-life

companies.

� P&C insurers often neglected ALM in the past (maybe for a good reason),

however, under Solvency II an AL mismatch will be visible and might also hurt.

4

Breakdown of the solvency capital requirement (SCR)

5

= included in the adjustment for the

loss absorbing capacity of technical

provisions under the modular

approach

Basic SolvencyCapital Requirement

Basic SolvencyCapital Requirement

Solvency Capital Requirement

Solvency Capital Requirement

AdjustmentsAdjustments Operational riskOperational risk

Non-life underwriting risk

Non-life underwriting risk

PremiumReserve

PremiumReserve

CatastropheCatastrophe

PremiumReserve

PremiumReserve

LapseLapse

Intangible assets risk

Intangible assets risk

LapseLapse

Interest rateInterest rate

EquityEquity

PropertyProperty

SpreadSpread

CurrencyCurrency

ConcentrationConcentration

IlliquidityIlliquidity

Non-similar tolife techniques

Non-similar tolife techniques

Similar tolife techniques

Similar tolife techniques CatastropheCatastrophe

MortalityMortality

LongevityLongevity

DisabilityMorbidity

DisabilityMorbidity

LapseLapse

ExpensesExpenses

RevisionRevision

MortalityMortality

LongevityLongevity

DisabilityMorbidity

DisabilityMorbidity

LapseLapse

ExpensesExpenses

RevisionRevision

CatastropheCatastrophe

Source: European Commission

QIS 5 results Germany – life insurance

6Source: BaFin

QIS 5 results Germany – P&C insurance

7Source: BaFin

QIS 5 results – UK

8Source: FSA

Solvency Capital Requirement Market risk component

Market risk – Slovenia non-life

Contribution in % (weighted average)

MarketMarket

100%100%

Interest rateInterest rate SpreadSpreadEquityEquity PropertyProperty

CurrencyCurrency ConcentrationConcentration IlliquidityIlliquidity

DivDiv

-65.0%-65.0%

33.2%33.2% 27.3%27.3%52.9%52.9% 0.5%0.5%

9.7%9.7% 39.3%39.3% 2.0%2.0%

Non-Life

Non-LifeMarketMarket HealthHealth DefaultDefault LifeLife Intang.Intang.

87.5%87.5%18.2%18.2% 1.8%1.8% 10.5%10.5% 0.0%0.0% 0.1%0.1%

Basic SCRBasic SCR

100%100%

DivDiv

-18.0%-18.0%

9

Source: AZN

Solvency Capital Requirement Market risk component

Market risk – Slovenia composite

Contribution in % (weighted average)

MarketMarket

100%100%

Interest rateInterest rate SpreadSpreadEquityEquity PropertyProperty

CurrencyCurrency ConcentrationConcentration IlliquidityIlliquidity

DivDiv

-51.3%-51.3%

29.1%29.1% 30.0%30.0%47.2%47.2% 10.2%10.2%

22.1%22.1% 5.7%5.7% 7.0%7.0%

Non-Life

Non-LifeMarketMarket HealthHealth DefaultDefault LifeLife Intang.Intang.

19.9%19.9%66.5%66.5% 9,5%9,5% 6.7%6.7% 32.1%32.1% 0.2%0.2%

Basic SCRBasic SCR

100%100%

DivDiv

-34.9%-34.9%

10

Source: AZN

THE LIABILITY DRIVEN INVESTMENT PROCESS

AT MUNICH RE

Asset-Liability-Mismatch Risk: fluctuation in economic

surplus

� Asset-Liability-Mismatch risk is the

uncertainty to suffer a loss of surplus value

due to changes in capital market factors

� Here, surplus value is defined as difference

between market value of tangible assets and

market consistent value of current liabilities

� Capital market factors are:

� Currency

� Interest rates

� Inflation

� Credit

� Equity

� Asset-Liability-Mismatch risk is the

uncertainty to suffer a loss of surplus value

due to changes in capital market factors

� Here, surplus value is defined as difference

between market value of tangible assets and

market consistent value of current liabilities

� Capital market factors are:

� Currency

� Interest rates

� Inflation

� Credit

� Equity

_=

AL-Mismatch Risk

12

The Liability Driven Investment Process of Munich Re

Real A

ssets

Real A

ssets

Benchm

ark

Portfo

lioB

enchm

ark

Portfo

lio

Market Risk

Replic

atin

g P

ortfo

lioR

eplic

atin

g P

ortfo

lio

Characteristics

of liabilities with

respect to capital

markets

Characteristics

of liabilities with

respect to capital

markets

Econom

ic N

eutra

l Positio

nE

conom

ic N

eutra

l Positio

nS

urp

lus

Surp

lus

Risk minimal

preference for

surplus funds is

added

Risk minimal

preference for

surplus funds is

added

strategic risk

preference

restricts possible

deviation from

risk minimum

BMP translates

risk appetite into

investable

benchmark

BMP translates

risk appetite into

investable

benchmark

MEAG Asset

Management

skills

MEAG Asset

Management

skills

Lia

bilitie

sLia

bilitie

s

13

REPLICATING PORTFOLIO

Definition Replicating Portfolio

Investable portfolio that replicates the tradable risk factors within the liabilities and minimizes the

fluctuation of economic capital (minimal AL-Mismatch Risk).

Objective: Separation of tradable

and non-tradable risk factors

Tradeable factors

(hedgeable)

� Responsibility of Investments!

� Tradable Risks are:

� Currency Risk

� Interest Rate Risk

� Inflation Risk

� etc.

Non-Tradable

(non- hedgeable)

� Responsibility of Insurance

� Non-tradable risks are:

� NatCat

� Fire

� etc.

With the Replicating Portfolio we translate the liabilities

into the language of investments

15

Replicating Portfolio: Minimizing AL-Mismatch risk by

replication; free surplus in local cash

16

The replication of future payouts from claims on the investment side and the investment of

economic surplus in risk free cash minimizes the AL-Mismatch Risk

Investment of assets covering

liabilities:

�10 Mio. EUR Gov Bond, due in 10 years

�3 Mio. USD Gov Bond, due in 3 years

�8 Mio GBP Gov Inflation Linked Bond, due

in 8 years

Investment of economic surplus:

� Local CashRisk free

Parallel

change in

value of

assets and

liabilities

1 2 3 4 5 6 7 8 9 10 11 12

Cash Flow Assets

Future Payments:

�10 Mio. EUR in 10 years

�3 Mio. USD in 3 years

�8 Mio GBP in 8 years, Inflation-sensitive

1 2 3 4 5 6 7 8 9 10 11 12

Cash Flow Liabilities

BENCHMARKPORTFOLIO

The preference for AL-mismatch risk is transformed

into an investable benchmark portfolio

Board of

Management‘s

strategic

preference for

AL-risk

Capital asset

pricing model

simulates future

return scenarios

Optimization

of

AL-mismatch

(Assets –ENP)

Investable

BMP

External Restrictions

(rating agencies,

statutory restrictions,

etc.)

18

Investing free surplus following the risk preference of

the board of management

19

Integration of strategic AL-Mismatch by exchanging risk-free cash investments with risky

investments leads to the Benchmark Portfolio (BMP)

Investment of assets covering

liabilities:

�10 Mio. EUR Gov Bond, due in 10 years

�3 Mio. USD Gov Bond, due in 3 years

�8 Mio GBP Gov Inflation Linked Bond, due

in 8 years

Investment of economic surplus:

� Local Cash

� Risky Assets (Equity, Credit, ….)risk

preference

Parallel

change in

value of

assets and

liabilities

1 2 3 4 5 6 7 8 9 10 11 12

Cash Flow Assets

Future Payments:

�10 Mio. EUR in 10 years

�3 Mio. USD in 3 years

�8 Mio GBP in 8 years, Inflation-sensitive

1 2 3 4 5 6 7 8 9 10 11 12

Cash Flow Liabilities

Identifing the optimal asset allocation using the efficient

frontier

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0% 5% 10% 15% 20% 25% 30% 35%

Exce

ss R

etur

n

VaR 99.5%

Optimierte Linie effizienter Kapitalanlageportfolien

Current allocationEfficient frontier

Less Risk

Efficient frontier of Benchmark Portfolios

Replicating portfolio

More

Return

1,75 x 99,5% VaR

Excess-R

etu

rn

20

Internal ALM process leads to stable investment

income of Munich Re

EquityEquity

CashCash

GovernmentsGovernments

Non GovernmentsNon Governments

Alternatives incl. Real EstateAlternatives incl. Real Estate0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2007 2008 2009 2010

21

Idea was born to offer internal ALM process and systems to clients -> ALPHA

Internal ALM process helped Munich Re getting through the financial crisis without loosing

significant investment return

ALPHA – ALM CONSULTING SERVICE OF MUNICH

RE

Solvency II rewards appropriate ALM –

Munich Re offers the whole ALM-value-chain

ALPHA service in a nutshell

MR offers its know-how to its clients – from loss analysis to asset management:

�Data analysis and projection of future loss development

�Determination of the run-off/payout pattern

�Market-consistent valuation of reserves

�Determining investment position with minimum risk

�Determining the investment position with the best risk-return profile

�Optional: Holistic asset management specifically for insurance companies

ALPHA – our service

� Compatible systems

� An uninterrupted process chain

� Defined interfaces for implementation of

management requirements

� New methodologies for economic

valuation and risk modeling

� Comprehensive reporting

ALPHA – success factors

23

Benchmark

Portfolio

(BMP)

Asset

management

Economic

valuation

Cash

Flow

Loss

data

lossespremium

liability data,

optional: asset dataoptionalanalysis and support

trad.

RI

MR internal process chainMR internal process chain

Risk Neutral

Position

(RNP)

� Using ALPHA enables to profit directly from Munich Re techniques and experience

� We offer ALPHA either as a full outsourcing of the process chain or in modules

� Using ALPHA enables to profit directly from Munich Re techniques and experience

� We offer ALPHA either as a full outsourcing of the process chain or in modules

client

Creating value through ALM

Assume a non life insurance company with:

� 200 mio € assets

� Expected investment return: 3% p.a.

� Risk capital for market risk: 15 mio €

ALM study shows ways to either:

� Reduce risk capital (for the market risk) from 15 mio € to 10 mio €, assume cost of

capital = 10%, i.e. saving of 0.5 mio € (not taking into account diversification

effects with underwriting risk)

� Increase expected return from 3% to 3.25%, i.e. 25 bp. That means additional

0.25% x 200 mio € = 0.5 mio €

24

© 2011 Münchener Rückversicherungs-Gesellschaft Aktiengesellschaft in München

("Munich Re"). All rights reserved.

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the arrangement thereof) is protected under copyright law and other protective legislation.

These materials or any portions thereof may be used solely for personal and non-commercial

purposes. Any other use requires Munich Re’s prior written approval.

Munich Re has used its discretion, best judgement and every reasonable effort in compiling the

information and components contained in this presentation. It may not be held liable, however,

for the completeness, correctness, topicality and technical accuracy of any information

contained herein. Munich Re assumes no liability with regard to updating the information or

other content provided in this presentation or to adapting this to conform with future events or

developments.

Disclaimer

25

THANK YOU VERY MUCH FOR YOUR ATTENTION

Michael Gerstle Rainer Stragies

Tel. +49 89 3891 3841 Tel. +49 89 3891 9650

mgerstle@munichre.com rstragies@munichre.com

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