Speaker : SONJAI KUMAR

Company : AVIVA LIFE INSURANCE

AGENDA

► Why is Assets and Liability Management (ALM) necessary in the life insurance business for its financial health and what are the implications?

► How assets and liability management is performed in the life insurance business?

► What are the factors affecting the ALM?

► What are the issues and challenges in the Indian market in managing the ALM risk?

► What are the simple measures used in managing the ALM risk?

To manage Change in interest rate risk?

Assets Liability

Longer in term

Sho

rte

r in

Te

rm

Change in Liability

Change in Assets Change in Assets

minus Liability

Risk= Exposure*Duration Gap

Impact the bottom line

Delta “I”

(ALM)

Nature of Liability- types of Products

Unit Linked Products

Non-Participating Product in Profit

Participating Product in Profit

Maturity depends on Market Value

Guaranteed Liability on Maturity

Guaranteed + Discretionary

Benefit

No ALM Risk High ALM Risk Medium ALM RiskIncreasing Guarantees with term through bonus additions

2001-2010 2010 Post 2010

Pre-dominantly ULIP were sold

IRDA-SEBI Spat on ULIP products and subsequent restrictions on charges by IRDA

Market moved to Traditional Products

Indian Product Market Scenario

Par

Non-Par

Many Players Selling Par

Many Players Selling Term product with only death benefit

Some players are selling products with maturity guarantee

X

Par Non-Par

Guaranteed Sum Assured (GSA)- Small in Amount

Bonus (B) every year that becomes guaranteed on

maturity and Death

Death Benefit = GSA + BBonus declared up to time of

death

Maturity = GSA+B+TBTB= Terminal Bonus

Guaranteed Sum Assured (GSA)

Bonus = NIL

Death Benefit = GSA

Maturity = GSA

Total Pay out Rs.500,000/-

Total Bonus= 300,000

Similar to fixed and floating

interest rate

GSA = 200,000

Time

Benefits

Rs.500,000

Par Non-Par

Increasing Guarantee but has a slow increasing Guarantee

Interest rate risk is medium/low

ALM is important

Maturity = GSA+B+TBTB= Terminal Bonus

Has Guarantee at the on set

Interest rate risk is very high

ALM is very important

Current risk in the Indian Market is from fall in future interest rate

Focus Point

Lets look at a simple example:

► An insurance company collects premium from customers and provides a guaranteed return of 6% over the policy period (which is say 20 years);

► Further, the premium collected from customers is invested in Corporate Bonds/Govt Securities at a return of 8%.

6 months later, the interest rate falls to 5%. What’s the impact on the insurance company:

► Insurance company faces the risk of reinvestment of future premium at lower interest rates. Incase fall in interest rate is permanent, the company may have to pay from its pocket as the returns are guaranteed for the customer.

In the above scenario, what would be the risk if interest rates were to fall to 7% in place of 5%?

► Profit Margins will get compressed as the Insurer will earn less return on the investment.

So an insurer has a risk of ‘falling’ interest rate.

Reinvestment Risk

Liability Duration at times has

absurd value

Liquidity Risk

In the event of fall in interest

rate future premium will be

invested at higher price

Due to the nature of the liability cash

flows, duration value is assured

For a long term products such as

whole life product,

maximum term of assets could be around 30

years or so

Hedging instrument

Shorter Asset Term

Indian Regulator has just allowed

using interest rate derivatives

to hedge the risk.

Initial days

In case of mass surrender, risk

of liquidity

Assets Longer than Liability Liability Longer than Assets

Rise in Interest rate is a risk

Assets to be sold @ cheaper price on liability maturity

Example- General Insurance and Health Insurance Products

Shareholder’s Fund

Fall in interest rate is a risk

Reinvestment risk of future premium

Typical Life Insurance long term products

Maturity = GSA

Invest Short term Invest longer term

Duration Matching

Cash flow matching

Regulatory minimum

requirement

Some players are matching

duration of assets and liability

Project Assets and Liability cash flow into future

and invest assets based on the

visual gap

Calculate exposure on

change in interest rate by 1 bps

Strategic Assets Allocation

It has its own challenges

Simple, but lack quantification

PVBP

Some may be using

Allocate Assets on criteria such

as profit, keeping risk within

appetite and stay within

constraints

?

Change in Liability

Assets Optimization

Constraints

Performance indicator

Risk Indicator

Policyholder

Shareholder

Risk Appetite/Tolerance

Duration

Regulatory

Overall Match by “Nature”, “Term &

"Currency” of Liability

Assets Liability Default

Assets are Longer- Loans

Liabilities are shorter-Deposits

Liquidity risk is more

prominent

ProductsLiquidity

What can be learnt ?

Assets are Shorter

Liabilities are Longer

Liquidity risk is less

prominent

Par and Non-Par

Floating and Fixed Rates

Premium Lapse

EMI Default

Ban

kin

gLi

fe

Insu

ran

ce

Level PremiumIncreasing Benefits

in a probabilistic sense

Shorter Tenure of Assets

Liability are due to the customer and

Cannot be adjusted

ALM focus on Optimizing assets

portfolio given the liability

Match Assets by “Nature”, “Term &

"Currency” of Liability

YearPremium

Income

Gross

Interest

Income

Initial

Expenses

Renewal

Expenses

Initial

Commission

Renewal

Commission

Death

Claim

Survival

Benefit**

Surrender

ClaimsNet CF

1 500,000 15,843 160,700 613 148,250 - 10,144 - 20,923 175,212

2 423,449 35,658 - 4,630 - 21,172 9,521 - 44,704 379,079

3 379,565 56,812 - 4,409 - 7,591 9,393 - 28,341 386,643

4 358,985 77,351 - 4,431 - 7,180 9,726 - 35,724 379,275

5 339,377 97,241 - 4,455 - 6,788 10,019 - 42,197 373,159

6 320,699 135,548 - 4,476 - 6,414 10,279 - 47,828 387,250

7 302,912 163,594 - 4,495 - 6,058 10,501 - 53,734 391,719

8 285,977 192,719 - 4,514 - 5,720 10,697 - 66,470 391,296

9 269,856 222,536 - 4,532 - 5,397 10,877 - 77,759 393,827

10 254,510 243,072 - 4,548 - 5,090 11,048 - 89,016 387,879

11 239,902 262,527 - 4,563 - 4,798 11,220 - 104,672 377,176

12 225,995 210,974 - 4,574 - 4,520 11,383 - - 416,492

13 - 214,719 - 2,490 - - - 335,927 - (123,697)

14 - 282,097 - 2,420 - - - 335,927 - (56,250)

15 - 269,784 - 2,347 - - - 335,927 - (68,490)

16 - 224,732 - 2,271 - - - 335,927 - (113,466)

17 - 243,153 - 2,191 - - - 335,927 - (94,964)

18 - 202,617 - 2,107 - - - 335,927 - (135,416)

19 - 189,287 - 2,019 - - - 335,927 - (148,659)

20 - 134,452 - 1,927 - - - 335,927 - (203,401)

21 - 158,698 - 1,831 - - - 335,927 - (179,060)

22 - 143,426 - 1,730 - - - 335,927 - (194,230)

23 - 127,384 - 1,624 - - - 335,927 - (210,166)

24 - 110,533 - 1,448 - - - 1,679,634 - (1,570,549)

-2000000

-1500000

-1000000

-500000

0

500000

1000000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Net CF

YearPremium

Income

Gross

Interest

Income

Initial

Expenses

Renewal

Expenses

Initial

Commission

Renewal

Commission

Death

Claim

Survival

Benefit**

Surrender

ClaimsNet CF

Increase in

Reserve

Gross

Surplus

1 500,000 15,843 160,700 613 148,250 - 10,144 - 20,923 175,212 237,862 (62,650)

2 423,449 35,658 - 4,630 - 21,172 9,521 - 44,704 379,079 358,996 20,082

3 379,565 56,812 - 4,409 - 7,591 9,393 - 28,341 386,643 365,418 21,224

4 358,985 77,351 - 4,431 - 7,180 9,726 - 35,724 379,275 353,574 25,701

5 339,377 97,241 - 4,455 - 6,788 10,019 - 42,197 373,159 342,795 30,365

6 320,699 135,548 - 4,476 - 6,414 10,279 - 47,828 387,250 316,062 71,187

7 302,912 163,594 - 4,495 - 6,058 10,501 - 53,734 391,719 303,941 87,778

8 285,977 192,719 - 4,514 - 5,720 10,697 - 66,470 391,296 288,519 102,778

9 269,856 222,536 - 4,532 - 5,397 10,877 - 77,759 393,827 274,354 119,472

10 254,510 243,072 - 4,548 - 5,090 11,048 - 89,016 387,879 260,457 127,422

11 239,902 262,527 - 4,563 - 4,798 11,220 - 104,672 377,176 244,320 132,856

12 225,995 210,974 - 4,574 - 4,520 11,383 - - 416,492 375,844 40,648

13 - 214,719 - 2,490 - - - 335,927 - (123,697) (149,039) 25,342

14 - 282,097 - 2,420 - - - 335,927 - (56,250) (156,558) 100,308

15 - 269,784 - 2,347 - - - 335,927 - (68,490) (164,456) 95,967

16 - 224,732 - 2,271 - - - 335,927 - (113,466) (172,753) 59,287

17 - 243,153 - 2,191 - - - 335,927 - (94,964) (181,469) 86,505

18 - 202,617 - 2,107 - - - 335,927 - (135,416) (190,625) 55,209

19 - 189,287 - 2,019 - - - 335,927 - (148,659) (200,243) 51,584

20 - 134,452 - 1,927 - - - 335,927 - (203,401) (210,347) 6,945

21 - 158,698 - 1,831 - - - 335,927 - (179,060) (220,960) 41,901

22 - 143,426 - 1,730 - - - 335,927 - (194,230) (232,110) 37,880

23 - 127,384 - 1,624 - - - 335,927 - (210,166) (243,823) 33,656

24 - 110,533 - 1,448 - - - 1,679,634 - (1,570,549) (1,599,759) 29,210

-100000

-50000

0

50000

100000

150000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Gross Surplus

Year 1 Reserves: INR 237,862

Purchase assets equal to the value of INR 237,862

Questions

How to purchase assets equivalent to INR 237,862:

► What will be the term of the Bonds?

► How much money you will be kept in short term assets to maintain liquidity ?

► What should be the optimal mix of assets?

Answers

Asset purchasing philosophy: Purchase assets in a manner that it matches the:

► Nature of Liability (Guaranteed, Discretionary, Linked),

► Term (Duration of assets = Duration of Liability), and;

► Currency of Liability (Invest in same currency as liability)

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