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Asset Liability Management atMunich Reinsurance Company
Helsinki, 17th November 2004
Bernhard Kaufmann and Jochen Mayer
2
Asset-liability management for insurance companies
� ALM: Governance and Management
� The Munich Re ALM-Model: ALM on Macro Level
� The general Concept
� The different modules
� Reports and Analysis
� ALM and pricing: ALM on Micro Level
Agenda
3
Asset-liability management for insurance companies
Strategic objectives for ALM
Business focusOperational profitability Risk limitation Financial strength
– Reinsurance
• Focus on achievinga leading marketposition in targetmarkets dependingon the cycle
• Exit business notachieving targetreturns
– Primary insurance
• Strong platform forprofitable growth
• Sustainablestrengthening ofbusiness model
– Strict underwritingdiscipline
– Rigorous applicationof Value BasedManagement
– Commitment tofinancial targets
- Comprehensive riskmanagement
– Integrated view oninsurance risk andfinancial mismatchrisk
– De-risk balancesheet
– Retain clients’ andinvestors’ confidence
– Reduce dependencyon equity marketdevelopments,thereby increasingflexibility
Deliver a return to shareholders in excess of cost of capital
4
Asset-liability management for insurance companies
Evolution of ALM in global insurance market
4
• Development of coherent Integrated Risk ManagementFramework
• ALM processes integrated with active capital managementand other financial risk management processes
• Governance processes provides independent oversight ofaggregate financial risk position
1• Identification, measurement and monitoring of asset
and liability risks undertaken in isolation, with varyingdegrees of sophistication
• Limited or informal / ad hoc integration of individualrisk profiles
3
• ALM function and processes developed to integrate riskprofiles of both assets and liabilities
• Management action focused on the integrated asset andliability view
• Governance process provides independent oversight ofALM
2
• Enhanced awareness of the value of formalized ALMprocess
• Development of partially integrated asset and liabilitymeasurement processes
• ALM governance primarily focused on asset-side
66% ofinsurers are
less than 50%of the way
through theevolutionary
journey
90% ofinsurers
believe thatbenefits
outweigh thecosts of the
journey
Source: Ernst & Young LLP. 2004
5
Asset-liability management for insurance companies
ALM in the Solvency II project
Special Call for advise from CEIOPS (MARKT/2506/04-EN – App.2):
… “In the future all insurance undertakings need to have an asset-liability
management system (ALM) as part of their general business and risk
management processes. General principles concerning A/L analysis shall be
harmonized at the EU level.”…
... “One major use for ALM in pillar I is to contribute to investment planning.” …
… “standard formula for calculating the solvency capital requirement should
capture the ALM risk in a sufficiently prudent approach.” …
… “The pillar II supervisory review process should encompass the undertaking’s
ALM.” …
6
Asset-liability management for insurance companies
Stochasticrepresentation ofcash flowsassociated withinsurance andreinsuranceobligations on aclass of business
Portfolio ofassets that mostclosely matchesthe riskcharacteristicsassociated withthe stochasticrepresentation ofthe liabilities
Asset allocationtargets thatprovide optimallevel of returngiven thepredeterminedappetite of Boardand otherinvestmentconstraints, asdictated byexternalstakeholders (e.g.regulators, ratingagencies)
Asset allocationtargets that areselected by theAsset Managerto optimizereturn withingiveninvestment andrisk constraints
The risks andcash flowsassociated withassets of theGroup
LIABILITIES REPLICATINGPORTFOLIO
STRATEGICASSET
ALLOCATION
TACTICALASSET
ALLOCATION
ASSETS
ALMGOVERNANCE
ALM Governance of Munich Re Group
7
Asset-liability management for insurance companies
� ALM: Governance and Management
� The Munich Re ALM-Model: ALM on Macro Level
� The general concept
� The different modules
� Reports and Analysis
� ALM and pricing: ALM on Micro Level
Agenda
8
Asset-liability management for insurance companies
What would happen if? The ALM model is anevaluation tool
An optimisation toolgenerates, for example, astrategic asset allocation
The ALM model simulates theimplications of the consideredSAA over a 5 year horizon incombination with the liabilities
The AL-team analyses thesimulated results for the
considered SAA and tradesoff risks and chances
Capital market model
Reports
Asset moduleLiability model
Life Non life
Corporate model
“The optimiser”
“The ALM model”
“The AL-team”
9
Asset-liability management for insurance companies
Volatility sources
Capital marketscenarios
Operativebusiness
The ALM model allows to analyse the impact ofstrategic decisions and changes in the general framework
General framework
Accounting rules
Regulation
Strategic decision
Investment strategy
Operative strategy
Distributions ofcorporate results
Balance sheet
P&L statement
Risk positions
ALM-Model
10
Asset-liability management for insurance companies
� ALM: Governance and Management
� The Munich Re ALM-Model: ALM on Macro Level
� The general Concept
� The different modules
� Reports and Analysis
� ALM and pricing: ALM on Micro Level
Agenda
11
Asset-liability management for insurance companies
The different Modules
Sub models
Corporate model
Capital market model
Asset model Liability model
Reports
IFRSHGB
12
Asset-liability management for insurance companies
The capital market model: 3000 Scenarios form the basis ofthe ALM simulation
EURO Zinsraten über einen 5-Jahres-Horizont
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1 Y 3 Y 5 Y 7 Y 10 YMaturity
Inte
rest
rat
e
1% quantile 5% quantile 10% quantile 25% quantile 50% quantile 75% quantile
90% quantile 95% quantile 99% quantile start mean
� Short term interest rates are more volatile than long termrates
� For most of the scenarios interest rates are below theaverage
� In many of the scenarios the spread between long andshort term rates reduces over time
13
Asset-liability management for insurance companies
The capital market model: Equity indices
EUROSTOXX
-
1.000
2.000
3.000
4.000
5.000
6.000
7.000
8.000
9.000
10.000
1 Year 3 Years 5 Years
Horizon
Val
ue
� The mean of the chosen calibration is clearly positive: 5-year return EUROSTOXX: 6,7% p.a.
� The probability of a loss for the EUROSTOXX isnevertheless very high at 28%.
14
Asset-liability management for insurance companies
MODELLING EURO ASSETS - IAS
Governments
Participations
Allianz
Ergo
Commerzbank
Corporates
Pfandbriefe
(ABS/MBS)
Equities
Loans
HVB
Cash
Real Estate
Insurance index anddividend yield
Relevant price index anddivident yield (Eurostoxx)
(Dynamic Spreads)
Static Spreads
Interest yield curve (term)
Banking index anddividend yield
Relevant real estate index
Short term interest rate
Price index and dividendyield (DAX)
Asset Classes Market value modelling
Real Estate
Affiliated Companies -consolidated
Associated Companies
Bonds – Available for sale
Bonds – Held to maturity
Bonds – Trading
Book value modelling IAS
Loans
Equity – Available for sale
Equity - Trading
Affiliated Companies –non consolidated
Cash
MarketValue
MarketValue
MarketValue
MarketValue
+
The asset model: Focus of the analysis should rule thegranularity of the model
15
Asset-liability management for insurance companies
� Flexible premium and budget development (GDP, CPI)
� Consideration of internal/external retrocession and FRe-treaties
� Derivation of commission and admin expenses as ratios of earned premiums
The non life model simulates catastrophe, basicand large losses based on MR risk model
Claims
Non-Life Module
Interaction withother modules
Input
Ext. Retro Finite Re
Output
Division Report
LoB Report
Currency Report
Input Input
� Cash Flows
� Balance sheet
�Income statement
INCURRED LOSSES AND PROVISIONS FOR OUTSTANDING CLAIMS ARE PROCESSED BY MEANS OF
STOCHASTIC PAY OUT PATTERN
Major Non-Life Loss and Combined Ratios (Mean and Quartiles)
0%
30%
60%
90%
120%
150%
180%
210%
20
03
20
04
20
05
20
06
20
07
20
03
20
04
20
05
20
06
20
07
20
03
20
04
20
05
20
06
20
07
20
03
20
04
20
05
20
06
20
07
Casualty OtherMarineProperty
16
Asset-liability management for insurance companies
Life model: reserving is strongly affected by interest rates
Average "Umlaufrendite" over 10 years (yield in %)2)
3
3.5
4
4.5
5
5.5
6
2003 2004 2005 2006 2007 2008
Change in Interest Sensitive Reserves3)
0
0.005
0.01
0.015
0.02
0.025
0.03
2003 2004 2005 2006 2007
99%-Quantil
95%-Quantil
17
Asset-liability management for insurance companies
� ALM: Governance and Management
� The Munich Re ALM-Model: ALM on Macro Level
� The general Concept
� The different modules
� Reports and Analysis
� ALM and pricing: ALM on Micro Level
Agenda
18
Asset-liability management for insurance companies
A number of ALM reports can be generated
� Risk analysis
� Technical results
� Capital market model scenarios
� Return and growth
� International & local GAAPfinancial statements
� Investments and
investment result
19
Asset-liability management for insurance companies
Balance sheet IAS
€m mean over scenarios
ASSETS Actuals 2003 2004 2005 2006 2007
Intangible assets 131 130 130 130 130
InvestmentsI. Real Estate 1.050 1.040 990 978 1.068
II. Investments in affiliated and associated enterprises 6.808 6.823 6.825 6.826 6.828
III. Loans (mortgage loans, loans to aff/ass) 666 580 582 604 627
IV. Other Securities
- Available for sale (excluding Allianz) 14.459 14.557 14.939 15.764 17.014- Available for sale (Allianz only) 2.347 2.483 2.656 2.884 3.060- Trading 56 56 56 56 56Total 16.862 17.096 17.651 18.704 20.130
V. Other investments 11.893 12.527 12.620 12.956 13.054
Total 37.279 38.067 38.667 40.068 41.706
Ceded share of underwriting provisions 1.789 1.527 1.503 1.520 1.529
Other assets 4.499 4.584 4.711 4.729 4.724
Balancing item Assets 0 410 410 410 410
20
Asset-liability management for insurance companies
The ALM model simulates balance sheet and incomestatement numbers for MR AG under HGB and IFRS
� Development of insurance business,premiums and claims
1. Stochastically simulated figures− Incurred losses (gross and netexpenses for claims and benefits)− Gross and net underwriting provisions
2. (Deterministically) projected figures− Gross and net earned premiums− Gross written premiums
3. Derived figures (by ratios)− Commission and admin expense ratios− Loss ratios (LR)− Expense ratios (ER)− Combined ratios (CR):= LR + ER− Ins. business result ratio:= 1 _ LR _ ER
� Security and risk measures− Relevant rating figure (S&P CAR)− Relevant solvability figures (solo
solvency)− Value at risk− Currency over/under coverage− Duration missmatch
� Assets and investment return− Asset structure at book and market
values− Unrealised capital gains and losses− Net investment return (components)− RoI (referring to the average market
value of total investments)− Performance of selected asset classes− Duration
� Rentability− Return on equity (RoE)− Comprehensive income per equity
21
Asset-liability management for insurance companies
Example 1: Risk/return analysis for differentstrategic asset allocations (SAAs)
Unchanged SAA
Increase in equities(SAA with higher risk)
Decrease in equities(SAA with lower risk)
Mea
n
Standard Deviation
2004 2005
2006 2007
Comprehensive Income in € bn
22
Asset-liability management for insurance companies
Static investment strategy
Dynamic investmentstrategy linked to VaR-limit
Example 2: Impact of dynamic investmentstrategies
23
Asset-liability management for insurance companies
Example 3: Analysis of duration mismatch
Definition EUR-Duration: =
Change in market value of assets andliabilities if all interest rates change by100 basispoints
EUR-Duration:=
MacAulay-duration* market value * 0.01
24
Asset-liability management for insurance companies
Example 4: Analysis of currency mismatch atbook and market value
Def: Currency mismatch = Market value of assets - Market value of liabilities
25
Asset-liability management for insurance companies
The graph shows the change of the IAS profit as a result of the first-timeimplementation of IAS 32/39 (rev. 2003) compared to the previous version.
IAS Profit (in Billion EUR)
with 90%-Confidence bands
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
new
200
3
old
2003
new
200
4
old
200
4
new
200
5
old
2005
new
200
6
old
200
6
new
200
7
old
200
7
Example 5: Effect of changes in accountingstandards (e.g. after tax profit under IAS 39 old and new)
26
Asset-liability management for insurance companies
� ALM: Governance and Management
� The Munich Re ALM-Model: ALM on Macro Level
� The general Concept
� The different modules
� Reports and Analysis
� ALM and pricing: ALM on Micro Level
Agenda
27
Asset-liability management for insurance companies
Primary Life Insurance – the past must be placed inperspective, lessons have been learned for the future
-8%
-4%
0%
4%
8%
12%
1994 1996 1998 2000 2002 2004
Max Discount / "Min. G'teed Rate"
Market Value Raturn
Average Participation Rate
% PA
(1)
(2)
(3)
Start ofDeregulatedMarket
Market Value EarningsExceed Declared Rates(Surpluses Accumulated)
Market Value EarningsLess than Declared Rates(Draw Down of Surplus)
The Future
(1) Estimated for 1994 & 1995, Actual for later years(2) Before allowance for Terminal Bonus, typically in the range of 0.3% to 0.5%(3) Rate applying to business written in that year
Interlinking the Fundamentals
ALM
Pri
cin
g
Hedging
Dyn
amic
Bo
nu
s
German Life
28
Asset-liability management for insurance companies
Securing Risk Adequate Prices in German Primary LifeBusiness – Market Consistent Pricing of Guarantees
�What is meant by ‘market-consistent’ pricing of a guarantee?
� The cost of a portfolio of assets with the same pay-offs as guarantee
in all possible scenarios i.e. the cost of hedging risk
�Why is it useful?
� Pricing: Shareholder cost of writing guarantee
� Capital: Minimum capital required to hedge risks. Can indicate drivers
of risk-based capital requirements
�For simple guarantees, formula may be available:e.g. ‘plain-vanilla’ put
options => Black Scholes formula
�Insurance guarantees usually more complex : cost dependent on Bonus
and asset management rules
�Simple formula not available ���� Use simulation model
29
Asset-liability management for insurance companies
� Bonus Smoothing Policies (Annual &Terminal Bonus)
� Making use of direct bonusdeclaration („Direktgutschrift“)
� Consideration of cost of guaranteesand embedded options in settingbonus rates
� Special treatment for policies closeto maturity – proactively managingpolicyholders‘ reasonableexpectations
� Shareholder participation pre andpost 1994 Rules
Improving Capital Productivity Requires OptimisingManagement Actions on Both Sides of the Balance Sheet
Managing the Liabilities Managing the Assets
� Defining the Strategic AssetAllocation and PortfolioRebalancing Rules
� Developing a sound dynamichedging strategy
� Optimising reinvestment anddisinvestment decisions
� Management of unrealised gainsand losses
� Flexing the equity backing ratio inresponse to changing excesscapital levels
30
Asset-liability management for insurance companies
Active ALM can improve the risk/return profilesubstantially
VisionBusiness
Focus
Pri
cin
g
Dis
cip
line
Distribution & Cost Management
Risk
Man
agem
ent
Strategy
0
0.5
1
1.5Passive Policy (Market Consistent Cost) Dynamic Policy (Market Consistent Cost)
Passive BonusPolicy – Market
ConsistentCost
Dynamic BonusPolicy – Market
ConsistentCost
1.0 .1
in %AUM
Power of ManagementActions to Reduce Costs of
Guarantee & ImproveReturns for Shareholders
- ILLUSTRATION FORENDOWMENT ASSURANCE -
0%
50%
100%
150%Passive Policy (Market Consistent Cost) Dynamic Policy (Market Consistent Cost)
Assets Invested inBonds (Base
Case)
Assets Coveredby Structured
Hedge100 25
in%
- ILLUSTRATION FORENDOWMENT ASSURANCE -
Optimising InvestmentStrategy for Shareholder
Funds Provides LeveragedPotential to Improve Capital
Productivity
MARKET CONSISTENT PRICING ASSET/ LIABILITY MANAGEMENT
German Primary Life Business –Improving Capital Productivity
Required Shareholder Risk Capital
Thank you for your interest.
Münchener RückMunich Re Group