Strategic asset allocation: case study by Aspen Re – using the internal model to change asset strategy
Dr Marcus Foley, Aspen ReSam Worthington, Towers Watson
27 September 2013, Brussels
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Agenda
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Overview of strategic asset allocation (SAA)
Aspen: a case study of SAA
Overview of SAA
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Why are insurers revising their strategic asset allocation now?
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Profitability and risk management (on-going requirement)
Risk management Achieving best practice risk management
Returns Improving risk adjusted returns more generally
Stakeholder demand Improve shareholder ROE and reduce/maintain policyholder premiums
Competition React to competitors increasing their investment returns
Diversification Asset risk is a good diversifier of insurance risk (eg natural cat risk)
Catalysts for change
Regulatory Discounting liabilities, recognising diversification effects, ‘use test’
Investment markets Seek out alternative sources of return the current in low bond yield environment
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Capital teamInvestment teamBoard / executive management
Calibrate model for SAA
Define SAA scope and constraints
Analysis and recommendations Implementation
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§ Agree to review SAA
§ Define risk appetite*
§ Define opportunity set, investment beliefs and general constraints
§ Decide key risk/return metrics to use
§ Decide SAA approach
§ Establish in-house views on asset risk and return metrics
§ Calibrate ESG and asset returns to your views
§ Implement investment constraints
§ Run model and output key risk/return stats
§ Overlay qualitative investment analysis
§ Scenario analysis
§ SAA recommendations with clear rationale
§ Benchmark results with independent views and stress tests
*Note defining risk appetite is a substantial project in its own right
§ Agree SAA changes
§ Buy or build implementation ability
§ Manager selection
§ Negotiating terms
§ Review management information dashboard
§ Transition to new SAA
§ Dynamic asset allocation framework?
§ Periodic SAA review (i.e. annually)
What are the steps for implementing SAA?
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Aspen: a case study of SAAScope and constraints
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Background
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Background to Aspen
• Bermudian domiciled specialty P&C insurer and reinsurer• $8mm in investible assets• More than 800 people worldwide
Capital modelling team
• Capital model 10 years old• Built to inform business strategy
Board commissioned SAA review in late 2012 - two approaches1. Major investment house used their standard SAA approach2. Aspen’s capital modelling team used internal model with Towers Watson’s
SAA model
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Overview of work
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Board objectivesl Long term: to increase the group’s book valuel Short term: assess how to spend surplus capital
l Share buybackl Increasing investment risk appetite
External economic considerations• Historically low interest rates• Low yield on investment grade fixed income assets• Recent yield rebounding of sub-investment grade assets from credit
Internal considerationsl Capital constraintsl Balance sheet volatilityl Aggregation of asset and insurance risk
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Asset portfolio before SAA
Investment holdingsGovernment bond, agency 26%Investment grade credit 30%RMBS 15%High yield, CMBS, ABS+ Munis, derivatives 4%Equity 3%Cash 22%
High quality, fixed interest portfolioInterest rate duration around 2 years net of IR swap
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Aspen: a case study of SAAModelling and analysis
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A comparison of two SAA approaches
Analysis of last 3 years of returns
Volatility
Total return only
Using government bond proxy
From internal, asset manager and
Towers Watson forecasts
Capital requirement and volatility
Yield and total return
Using internal model projected liabilities
Investment house Aspen’s internal team
Assumed to be GaussianCaptures non-linear
dependency between assets and liabilities
ASSET RETURN CALIBRATION
RISK MEASURE
RETURN MEASURE
LIABILITIES MODELLED
DEPENDENCIES
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Investment house SAA summary
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Modelling analysis conclusionsl Significant diversification between fixed income instruments across the
credit spectruml High expected returns for credit (extrapolate rebound since 2008)l Equity unattractive due to its volatility
Recommendation: a significant switch from high rated corporates to sub-investment grade credit
Weaknesses
l Risk aggregation between assets and liabilities poorly capturedl Credit expected returns over-inflated
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-600
-500
-400
-300
-200
-100
-
100
200
300
400
1 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Expe
cted
Pro
fit ($
m)
Percentile
Breakdown of Asset Risk for Indicated Percentiles
Credit Risk Equity Risk Interest Rate Risk
Aspen’s modelling results: asset risk contribution to total risk
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l Interest rate risk is a material risk driver across the distributionl Tail risk is most strongly affected by credit risk
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Comparing investments: capital impact
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Credit assets increased capital requirements most
Equity had the highest long term expected return for a high level of risk
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Comparing portfolios: total return v RoE
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Most capital efficient investment options:l Invest in equity (high return and medium capital impact)l Switch from credit (rather than cash)l Invest in agency RMBS (medium return but low capital impact as capital is
insensitive to interest rate risk)
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Qualitative analysis: stress tests
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l Assessment of balance sheet volatility (infrequent but regular risk)l Determined maximum threshold for equity investment = 5%l Validation of quantitative model results = board comfort l Intuitive communication of risk
Assumptions Portfolio impact ($m)
Scenario Period Equity return Yield curve Spreads Base 5% Cash to equity
5% A-rated to equity
10% from treasuries and
A-rated to agency RMBS
and equity
Base 6.7% <+50bps zero 107 134 132 137
Asian Crisis 1997
Sep 1997 - Oct 1998 (13 months)
14.8% zero significant widening 103 162 168 172
Interest rate shock 1994
Apr 1993 - Dec 1994 (20 months)
4.2% approx +350 bps zero -317 -300 -263 -278
Credit Crunch 2008
May 2007 -Nov 2008 -53.5% zero extreme
widening -562 -776 -706 -702
Dotcom Crash 2001
Jan 2000 - Oct 2002 (33 months)
-45.4% zero significant widening -124 -305 -302 -297
Yield Curve Steepening +
Spread Widening
Prospective Scenario -3.0% +100 to +250
bpsmoderate widening -224 -236 -203 -217
Aspen: a case study of SAARecommendations
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Recommendations
Portfolio reallocation
Increase in total return ($m)
Increase in income ($m)
Increase in risk capital
($m)
ROE of additional
investment
5% from cash into equity 27 13 108 12%
5% from A-rated corps into equity 25 6 31 20%
10% from US treasuries and A-rated into agency RMBS and equity 30 14 30 46%
l Increased income due to two factors:l Increased risk appetite (taking on more risk)l More efficient asset allocation
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In May investment committee recommended a 5% investment in equity
Implementation
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Tactical consideration: easier to switch from cash than A-rated corporates
Since then, market movements mean EMD yields have risen materiallyl Used SAA analysis to identify EMD was attractive from a risk perspective.
Re-ran analysis with updated EMD yields
Changes implementedl 2.5% switch from cash to equity l 2.5% from A-rated corporate to EMD
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SAA possible because capital model is widely used and understood
Key takeaways
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Using the internal model liabilities can generate very different SAA results to using a liability proxy for a P&C insurer
Qualitative analysis was critical in providing:l validation of internal model analysisl an intuitive explanation to communicate results to the board
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