Portfolio Management
Asset Liability Management 101
Submitted by Lee Fig on Sun, 2011-06-05 13:21A recent project has involved many considerations when looking at sound Asset Liability practices and policies, particularly those applied to risk management and finance. I wish to share some of these with you.
Whilst the following list is not intended to be definitive, I hope that it helps you when approaching this area or implementing projects. Your successful technical implementation of your ALM or indeed portfolio management systems will hinge on approaching this from the right perspective.
Platforms such as Fidessa Latent Zero are highly customisable and it is important that the right considerations and issues are discussed at the outset.
A successful technical implementation of your ALM or indeed portfolio management systems will hinge on approaching this correctly. Is your intention to use ALM as part of a strategic decision-making framework to exploit opportunities to create value and optimize their risk/reward profile?
A. What should the ALM scope be? Review your objectives...
The ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities to achieve financial
objectives - what are the given set of risk tolerances and constraints of the institution?
ALM is critical for the sound financial management of any entity that invests to meet future cash flow needs within constraints. It is broader than risk mitigation is linked to the liability and investment management functions. Its vital element within an Enterprise Risk Management framework.
The desirability of applying ALM and the chosen ALM process will vary from entity to entity due to case-specific circumstances and preferences of each entity. The importance of ALM to an entity that focuses on managing risks for profit, and the sophistication of its ALM process, is different than that of an entity that has other sources of revenue.
B. So what is the "Entity"?
It refers to the organisation, pension plan, portfolio, individuals etc. This is obviously dependent upon the nature of the business. Sometimes the entity at risk and responsible organisation are different. There are often multiple organisations/individuals with an interest in the entity, e.g., regulators, counter-parties in other jurisdications individuals doing business with the entity etc. Just take a look at the legal contractual documentation with regards to complex derivatives.
But only one organisation bears the primary risk, as well as legal and fiscal responsibility. For insurance companies there is generally no difference between the entity at risk and responsible organisation. For other entities, these might be different. For example, the security/product is an entity for which the project sponsor has responsibility, but which is legally separate and managed in addition to the core business of the organisation.
The plan sponsor, who must weigh the risks generated by the plan against other risks incorporating Basel or Solvency II etc.
C. How do you define the client and your own portfolio?
Talk to relationship and customer managers. What are their requirements? Do they need a realtime dashboard view of the collection of assets, liabilities they happen to manage? For sales a portfolio may consist of a single asset or liability whereas brokers may take a more quantataive view risk exposure.
Take a look at the current operating model before focusing on the "To-be"s. For instance, producing updated Target Operating Models for Basel III invariably requires some initial gap analysis - looking at the operating environment, markets/customers and integrating with regulatory framework.
D. Consider assets and risk events
A simple (financial) asset is cash held or the right to receive cash, possibly contingent on a predetermined event, at future times. Some assets, such as derivatives, may have both asset and liability characteristics. So consider the product - it's complexity, structure, correlation with other products etc.
E. Understanding liabilities correctly will free up working capital to do more for you! Various regulatory initiatives are insistent upon (financial) liabilies being met when called upon. Being on the tail end of a margin card and being able to meet obligations to pay cash, possibly contingent on a predetermined event, now or in the future must always be considered when making investment decisons.
F. Integrate with your ENTERPRISE RISK MANAGEMENT framework
For Solvency II, the ORSA for example integrates with Treasury, Actuarial and other areas when performing reserving and capital management.
Simplarly within banking, consider how ALM integrates with your Basel Enterprise Risk Management operations - how it assesses, controls, measures, exploits, finances, and monitors risks from all sources for the purpose of increasing short and long-term value to stakeholders. ALM is an integral part of ERM.
G. And what do we mean my RISK?
I found the following principles/consideration, for a recent project, to be relevant:
- Risk exposure to an uncertain event or outcome that has a financial impact to which the business is not indifferent. For insurance and other financial institutions, risk is inherent in doing business. Risk captures the possibility of positive and negative deviations from an expected outcome.
Financial institutions and other entities may be exposed to many different types of risks, which can broadly be categorized as credit, market, operational, and insurance/underwriting risks.
- Risk tolerance of an entity is a degree of preference for a particular risk over a stated time horizon. Risk tolerances may be translated into risk limits that set the maximum allowable exposure (e.g., the maximum loss for a given confidence level, or the maximum change in economic value for a given change in a financial variable). For secrities, the risk tolerance considered is generally that of the project sponsor. The implementation plan should assume risk tolerance is influenced by regulatory and fiduciary constraints.
H. What about constraints?
Constraints are restrictions on the set of strategies that may be incorporated into an ALM process. Constraints may be either external or internal. External constraints include regulatory requirements, tax laws, and other legislative requirements. Internal constraints reflect management philosophy or professional judgment (such as asset allocation limits), which may be influenced by rating agencies, regulators, customers, and other stakeholders. Do not underestimate.
J. Review financial objectives - the business case, goals, platform costs etc.
Potential operational impacts of a new implementation require due dilegence. Financial objectives are the key financial priorities and goals help. These are generally determined by senior management and the board of directors.
The financial objectives most appropriate to the ALM process usually
focus on the long-term best interests of the policyholders, shareholders, and other stakeholders. Examples of financial objectives include maximizing economic value and accounting measures, including future net income, return on equity, statutory surplus, or current year earnings. Financial objectives for pension plans typically focus on the ability to cover obligations when due, with acceptable level and volatility of contributions, pension expense and funded levels.
K. Economic value must be understood to represent the long-term inherent value of the portfolio. Economic value is based on the portfoliob s future cash flows, as distinguished from values based on a specific accounting framework or funding requirements. Funding requirements and accounting-based values serve as a constraint on future cash flows. Such consideration are very relevant when looking at MI and BI.
L. And finally - test, test, test..
Build model scenarios using approriate quant based analytical tools. A scenario is a possible future state of the world. Scenarios are chosen to represent the possible future states of the world relevant to managing portfolios of assets and/or liabilities. The set of scenarios may represent the possible future values of financial instruments, such as bonds and stocks, inflation, term structure, credit spreads, ratings changes or defaults.
M. But don't forget about correlations!
The degree of correlation between two portfolios relative to a set of scenarios is a
measure reflecting the relative variation of the economic values of the portfolios over the set of scenarios. Two portfolios are said to be 100% positively correlated relative to a set of scenarios if the ratio of the economic values of the two portfolios is the same in each scenario in the set at each time period.
It is important to understand this when reviewing model test output. Linear relationships between variables are often assumed in finance and economics but true interdependencies may be considerably more complex. This frequently becomes apparent when integrating reviewing such output in the context of related processes. Configuring model parameter services and depends upon other business areas such as business Planning & Strategy. The business must be confident about the assumptions it makes about underwriting future liabilities and new business.
N - On hedging..
You may not be aware about to what extent you need to think and be equipped like a Hedge Fund manager. Hedging is the technique of designing a portfolio with cash flows that offset or defease another portfoliob s cash flows in certain scenarios. After hedging, the entity risk profile is more aligned with the entityb s risk tolerance. This technique allows the entity to become less concerned with which future scenario unfolds.
Thinking in these terms will help you to realise as much working capital whilst meeting and balancing the demands placed by regulators and business mechanics. I hope that this final thought will leave you with some food for thought and an inquisitive inclination when implementing ALM or other initiatives. Feel free to get in touch with your perspective.
