1. ALM in Asset Management CAS Spring Meeting - 20 May 2002 I N S U R A N C E A S S E T M A N A G E M E N T

2. 2 Outline What is the role of ALM in asset management? Definitions Theory Practice New use

3. 3 Effective Duration Rate Price with option without option PPP - + 0

4. 4 Liability Duration Selection of discount rate Reserves only or include future business Years of future business Rate of growth Expected v. Variable

5. 5 Yield curve expectations Duration matching assumes parallel shifts in yield curve Companies should be indifferent, but … Companies play directional guessing game –Higher yield  shorter duration –Lower yield  longer duration

6. 6 Bullet Concentrated around desired duration Expectation of a flatter yield curve

7. 7 Barbell Distributed around desired duration Expectation for steeper yield curve

8. 8 Conditional Immunization Decompose investment into components –CaseCash/Liquidity –IBNRDuration matched fixed income –SurplusEquity/longer fixed income/alternative Optimal component allocation  sub-optimal overall allocation –Similar to securities on deposit Transition inefficiencies LiquiditySurplusReserve 1 Year5-10 Years

9. 9 Yield Rolldown - Year 0

10. 10 Yield Rolldown - Year 1

11. 11 Yield Rolldown Obvious extreme example No credit exposure Liability Duration decay smaller than Asset Duration decay Yield curve has positive slope Liability discount rate not constant

12. 12 From Theory to Practice Theory of ALM not applied in practice Markets aren’t efficient Markets aren’t complete Liabilities don’t behave External restrictions

13. 13 Bond Price/Index Bonds traded over the counter –No definite price –Liquidity not guaranteed –Securities not homogenous Bond index defined by structure - not security –No published list –Broad criteria

14. 14 Risk Types

15. 15 Inter-Sector Excess Return Analysis As of 3/31/02

16. 16 Duration/Sector Allocation

17. 17 Security Selection

18. 18 Relative Municipal Yield Nominal vs. tax-equivalent percent yields at 3/31/02 Treasury AAA municipal bond

19. 19 Avoiding AMT Determine % income from municipal securities –Expected underwriting –Invest based on BOY assumptions Mid-year update –6/30 data available 7/15 –Analysis complete mid-August Rebalance allocation –Material differences in U/W results require massive rebalancing –Purchases may not be available –Sales might be unprofitable

20. 20 Conditional Asset Allocation ALM models used for asset allocation –Expected basis Catastrophes –Increase short term liquidity needs –Remove need for shielding –Possibly extend duration Use ALM models to develop liability catastrophe scenarios Model asset behavior in catastrophes Develop post-catastrophe allocation Develop transition plan