Managing ALM risks for life insurers in Asia

Asset-liability management (ALM) issues facing life insurers in Asia have grown in depth and scale since the 2008 financial crisis. What are the options given that traditional ALM techniques are much less efficient in this post-crisis world?

Life insurance policies are designed to provide peace of mind. Yet the business of selling policies is a big gamble these days for life insurance companies, confronted with asset-liability management (ALM) issues, notably those of duration gap, negative interest spread and balance-sheet volatility due to the spike in long-term volatility across most asset classes since the 2008 financial crisis.

These problems are particularly acute for life insurance companies in Asia ex-Japan where relatively illiquid long-term debt capital markets offer few opportunities in terms of yield enhancement, asset duration and portfolio diversification, says Karim Traoré, Hong Kong-based Financial Institutions Advisor at Société Générale Corporate & Investment Banking.

This is why life insurance companies need to move beyond traditional ALM techniques to innovative tailor-made structured solutions that are multi-dimensional in nature and are able to address simultaneously different constraints, such as those relating to return on economic capital, yield, volatility and accounting treatment, he notes.

“Traditional ALM techniques, whether investing in assets to reach specific benchmarks or investing in traditional assets to match specific liabilities, are hardly efficient anymore.

Life insurance companies in Asia need to think out of the box and turn to innovative solutions that are able to address not just one or two constraints, but five, six or seven constraints at one time because those solutions are designed for use in a multi-dimensional world, meaning that the solutions are specifically tailored for them and are able to address a set of constraints which sometimes might appear contradictory,” he adds.

MULTI-DIMENSIONAL ISSUES
Duration mismatch – a long-standing problem facing life insurers worldwide – is seen by Traoré to be particularly acute in Asia ex-Japan, where long-dated local currency bonds are in short supply.

“Most life insurance companies throughout Asia don’t necessarily have the resources or infrastructure to be able to select and conduct thorough due diligence on offshore bonds and select the right ones to add to their portfolio,” Traoré notes.
With long-term volatility at its peak, problems faced by life insurers have grown in dimension. “Although short-term volatility has eased from the 80% levels in the fall of 2008 at the peak of the crisis last year to around 25%, the VIX index is a false measure where insurance companies are concerned because they take a long term view. Long-term volatility is still at its peak.

“In the past when volatility was at low levels, life insurance companies throughout the region were more or less able to manage their risks correctly because hedging volatility was not that big an issue and the impact on the profit & loss account (P&L) was low. But with high levels of volatility currently seen across all asset classes, be it equities, commodities or bonds, this market volatility has translated into different areas of the balance sheets of insurance companies,” he adds.

Related to this is the issue of negative convexity faced by many Taiwanese insurers that have invested heavily in callable bonds.

“Having controlled volatility on the balance sheet might sometimes be good because volatility is viewed as negatively correlated in the long term to equity risk. The problem is actually one of concentration. Investing purely in negative convexity bearing products is not necessarily good because they concentrate the risk at the negative end of volatility. In this case, life insurance companies can diversify their risk by investing in positive convexity bearing products, which essentially are products that react positively in terms of value to an increase in volatility,” Traoré explains.

The impact of market volatility on insurers’ balance sheets has been exacerbated by marked-to-market requirements of International Financial Reporting Standards (IFRS) convergence and introduction of Risk-Based Capital (RBC) rules throughout Asia. “Although some countries in Asia have recently relaxed RBC rules, economic capital preservation remains a key concern,” he notes.

THE WAY FORWARD
Duration mismatch, long-term volatility and the need to address accounting, regulatory capital and economic capital issues are factors driving life insurers to turn to structured ALM solutions for hedging as well as yield enhancement purposes.
“People tend to identify structured solutions with structured credit, but a structured solution is much more than that. It is actually any type of solution that allows a life insurance company to address a wide range of concerns. You can tailor the solution so that life insurance companies can access the maturities and durations that they cannot find in domestic markets.

In some countries you can hardly find a liquid corporate debt instrument with maturity above seven years. With a structured investment solution, insurance companies can actually have a capital market partner issuing for them a ten-year or even longer private placement in their local operating currency. This allows them to mitigate the duration gap as well as the convexity of their net asset. They can also address something very important, which is economic capital, because structured solutions can be tailored such that it does not cost much in terms of economic capital,” he says.
Stressing the need for insurers to “think out of the box”, Traoré offers another word of advice for insurers: “Take a step back, identify first the risks on the balance sheet, where it is coming from, where the volatility is hidden. Identify where you have convexity, is it positive or negative, whether it comes from the asset side or the liability side.

Once you have done that, think about how you want to address those risks and rank the priority issues that you want to address. Usually, the number one issue is duration gap, followed by economic capital and then obviously the asset yield. But the priorities might not be the same for all insurance companies. Some of them might not care that much about duration mismatch, but they care specifically about having a very strong yield on the asset side compared to the liability side. Some of them have more risk-based capital objectives, and some simply want to make the most asset investment possible because they are cash rich and want both high yield and long duration,” says Traoré.

While structured solutions are tailored to address specific ALM needs and priorities of different insurers, they have one thing in common – they are all designed to provide peace of mind to companies to whom we turn in times of need.