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ASSET MANAGEMENT

within an

ALM FRAMEWORK

LE MRIDIEN SINGAPORE

SEPTEMBER 6 7, 2007Charles L. Gilbert, FSA, FCIA, CFA


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Focus on asset returns

Assets managed against benchmark Asset-only benchmark

Liability-driven benchmark

Investment (i.e. asset-only) objectives specified by client

Beating benchmark and/or achieving investment objectives does notnecessarily mean financial objectives will be met

Traditional Asset Management


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(80,000)

(70,000)

(60,000)

(50,000)

(40,000)

(30,000)

(20,000)

(10,000)

-

2006

2011

2016

2021

2026

2031

2036

2041

2046

2051

2056

2061

2066

2071

2076

2081

Pension Plan Liability Cash Flows

Duration = 15.4 years

Pension liabil ities: long-term and uncertain cash flows


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Asset Only Asset Liability

Focus on asset only return / pureasset performance

Does not capture risk exposure

Asset mix determined usingefficient frontier

Maximize risk-return trade-off toliabilities

Risk relative to liabilities moreclearly defined

Risk to solvency ratios reduced

Liability-Driven Investment ( LDI )

Approaches

Traditional Approach to

Pension Investment

Two approaches to managing pension assets


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Strategic asset allocation and selection of benchmark are the majorsources of returns and risk value added by asset manager against benchmark is lower order of magnitude

Investment strategy loosely recognizes risks associated with pensionliabilities investment objective is to maximize expected return for a given amount of risk

equities viewed as a good hedge against inflation, expected to outperform bonds in the

long term

Traditional approach applied to pensions


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E[R]

SAA determined using efficient frontier analysis

Minimize risk for a given level ofexpected return

Maximize expected return for agiven level of risk

Based on expected return,standard deviation and correlation

between asset classes


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Good asset manager can add value vs. benchmark:

Credit quality assessment capabilities based on fundamental analysis

Tactical asset allocation

Interest rate anticipation strategies

Other yield enhancement strategies

Benchmarks selected to manage assets


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Traditional approach for pensions uses asset-only benchmark

Benchmarks include

market indices Lehman Aggregate

S&P500

peer performance

quartile performance

May include duration target Focus is on total return of assets irrespective of performance of liabilities

Asset-only benchmarks


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Benchmark Weight

Index

Performance

Actual

Performance

Asset Manager

Outperformance

S&P500 60% 10% 11% 1%

Lehman Aggregate (5 yr duration) 40% 5% 6% 1%

Portfolio 100% 8% 9% 1%

Liabilities (15 yr duration) 6%

Solvency Ratio 103%

Asset-Only Benchmark Example:

No change in interest rates


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Asset-Only Benchmark Example:

Interest rates flatten long term rates down 1%

Benchmark Weight

Index

Performance

Actual

Performance

Asset Manager

Outperformance

S&P500 60% 10% 11% 1%Lehman Aggregate (5 yr duration) 40% 5% 6% 1%

Portfolio 100% 8% 9% 1%


Solvency Ratio 90%


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Funding Ratio - S&P 500 Pension Plans

60%

70%

80%

90%

100%

110%

120%

130%

140%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: Credit Suisse

Asset-only approach exposedpension plans to significant

risk Solvency deficits resulted

from falling interest rates andstock prices (so-calledPerfect Storm)

The perfect storm


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Pension crisis could have been avoided

Asset-only approach focused on achieving high asset returns irrespective

of liabilities Asset-Liability approach focuses on achieving asset returns that match

returns of liabilities1) increase in asset value greater than increase in liabilities and/or

2) decrease in asset value less than decrease in liabilities

Liability-Driven Investment framework


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Liability-Driven Benchmark Example:

No change in interest rates

Benchmark WeightIndex

PerformanceActual

PerformanceAsset ManagerOutperformance

S&P500 0% 10% N/A N/AReplicating Portfolio (15 years) 100% 6% 7% 1%

Portfolio 100% 6% 7% 1%


Solvency Ratio 101%


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Liability-Driven Benchmark Example:

Interest rates flatten long term rates down 1%


PerformanceActual


S&P500 0% 10% N/A N/AReplicating Portfolio (15 years) 100% 21% 22% 1%

Portfolio 100% 21% 22% 1%


Solvency Ratio 101%


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Liabil ity-Driven Benchmark plus Beta Example:

No change in interest rates / equit ies +10%


PerformanceActual


S&P500 50% 10% 11% 1%Duration 30 yr Pooled Fund 50% 6% 7% 1%

Portfolio 100% 8% 9% 1%


Solvency Ratio 103%


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Interest rates flatten / equities +10%


PerformanceActual


S&P500 50% 10% 11% 1%Duration 30 yr Pooled Fund 50% 36% 37% 1%

Portfolio 100% 23% 24% 1%


Solvency Ratio 102%


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No change in interest rates / equities 10%


PerformanceActual


S&P500 50% -10% -9% 1%Duration 30 yr Pooled Fund 50% 6% 7% 1%

Portfolio 100% -2% -1% 1%


Solvency Ratio 93%


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Interest rates flatten / equities 10%


PerformanceActual


S&P500 50% -10% -9% 1%Duration 30 yr Pooled Fund 50% 36% 37% 1%

Portfolio 100% 13% 14% 1%


Solvency Ratio 94%


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New developments focus on Liability-Driven approach

Greater focus on ALM due to financial losses

Global shift to marking-to-market of assets and liabilities

Regulatory pressure to accelerate funding of deficits New instruments enabling effective risk management

Move towards Principles-Based Approaches


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Liability Cash Flows

(60,000)

(40,000)

(20,000)

-

20,000

40,000

60,000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

2055

2060

2065

2070

2075

2080

Liability Cash Flows

substantial

reinvestment

rate riskexposure

pre-funding problem

Interest r isk remains significant challenge for insurers


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Replicating Portfolio Benchmark benchmark is derived as portfolio of zero-coupon bonds that replicates the liabilities

does not work well in practice for long-term liability cash flows

zero-coupon bonds do not exist at required maturities

Minimum Risk Portfolio Benchmark benchmark is derived from universe of available instruments that minimizes interest rate

risk exposure

similar to immunization strategy on a specified basis dollar duration, effective duration, partial duration, convexity, etc.

Liability-Driven Benchmarks


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Duration Matched

(200,000)

(100,000)

-

100,000

200,000

300,000

400,000

2006

2011

2016

2021

2026

2031

2036

2041

2046

2051

2056

2061

2066

2071

2076

2081

Asset Cash Flow s Liability Cash Flow s


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Economic surplus exposed to interest rate changes

Asset CashFlows

Liability CashFlows

Net CashFlows

Present Value 1,259,979 1,177,505 82,474

Duration 20.69 20.69 20.71

Dollar Duration 26,073,803 24,365,528 1,708,276

Convexity 520 573 (275)


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Interest rate risk exposure to non-parallel yield curve shifts

Partial Durations PARTIAL DURATION SENSITIVITY ANALYSISAsset Cash

Flows

Liability Cash

Flows

1 month (0.00043) (0.00052)3 month (0.00222) (0.00218)6 month (0.01327) (0.00831)1 year (0.05815) (0.03251)2 year (0.08661) (0.07642)3 year (0.27027) (0.19842)5 year (0.46674) (0.37466)7 year (0.27681) (0.48408)

10 year (0.43401) (0.52143)15 year (0.78572) 0.4657820 year 1.54432 2.2352825 year 6.34456 2.7579230 year 15.19911 16.93281

TOTAL 20.69376 20.69327

0

0 7 35 19106 145

-222

-69

1532

692

-4716

758

(5,000)

(4,000)

(3,000)

(2,000)

(1,000)

-

1,000

2,000

1

M

3

M

6

M

1

Y

2

Y

3

Y

5

Y

7

Y

10

Y

15

Y

20

Y

25

Y

0

Y


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Focus on financial objectives eliminate bets not being fairly compensated for taking

find best risk/reward solution (first optimize on default-free basis)

Assets managed directly against liabilities eliminates basis risk associated with using a benchmark

aligns portfolio manager incentives

difficult for most asset managers => requires sophisticated techniques

assets no longer separated => performance measurement not simple No need for client to specify separate investment objectives or try to

determine appropriate benchmark

ALM drives asset management

Greatest chance of achieving overall financial objectives and reducing risk

Asset Management within ALM Framework


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Overview of ALM implementation

EstablishConceptualFramework

DefineObjectives

AssignRoles &

Respons.

EstablishProcess

CustomizeTools &

Analytics

DevelopRisk

Reporting

SetOrg.

Structure

Identify /Describe

Risks

MeasureRisk

Exposure

DetermineRisk

Limits

BenchmarkCurrent

Practices

BoardApproval

FormulateStrategies

Conduct interviews with

Senior Mgt & Key Staff

Get Buy-In / Establish Risk Management Culture

Draft ALM Policy Statement and Procedure Manual


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Substantial value added through ALM

ALM Framework ALM conceptual framework defines

financial objectives, risk tolerances and constraints

how risk is measured

surplus management philosophy

*** Critical to get this right ***

ALM Policy Statement and Procedure Manual

sophisticated tools to manage exposure Integrated with ERM

framework for strategic decision making

use to achieve financial goals/maximize value

reduce risks not being compensated for simultaneously increase returns

ALM drives asset management shift focus from asset returns to overall financial objectives

ensures portfolio managers incentives are aligned with companys financial goals


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Assets managed directly against liabilities liability benchmarks replaced with actual liability cash flows

liability-driven benchmarks such as minimum risk portfolio and replicating portfolio

benchmarks are tools used to separate asset performance from ALM performance can be gamed

absolve portfolio manager from responsibility for overall ALM results

value added against benchmark is incremental by nature

Disciplined process ALM strategies are formulated to achieve financial objectives impact of trades on ALM results tested prior to execution

Substantial value added through ALM


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Impact on financial objectives broken down by source

Bets are made explicit

duration or rate anticipation credit selection

backing fixed income liabilities with non-fixed income assets

Value added by asset manager is transparent

Performance measurement is more meaningful but difficult to implement inpractice

Some companies feel that performance measurement of assetmanagement is less important than successful execution of ALM

Attribution analysis is challenging


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Questions?

Charles L. Gilbert, FSA, FCIA, CFA

[email protected]

www.nexusriskmanagement.com

07 Singapore Gilbert 02

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