using alm to drive investment strategy design · solutions alm is an ongoing process which requires...

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GE Asset Management

Using ALM to Drive Investment Strategy Design

This material has been created solely for use in a one-on-one presentation provided by GE Asset Management (GEAM) to institutional persons. It may only be used in furtherance of such presentation. The information presented herein is confidential and should not be copied or distributed without prior written consent of GEAM.Copyright © 2007 GE Asset Management Incorporated. All rights reserved.

Arthur Aaronson – GE Asset Management

See Important Disclosure Notes at End

1

Designing an Ideal Investment Policy

The main goal of an ideal investment policy is to grow and preserve capital while maintaining

liquidity to meet objectives.

We believe the use of Asset/Liability Management (ALM) Strategies helps develop an investment roadmap to meet business objectives and support long-term corporate strategies within an identified risk budget.

‒ Identifying investment opportunities with acceptable returns

‒ Appropriately defining risk measures

‒ Optimizing returns per unit of risk assumed


2

ALM IS A VITAL PART OF ENTERPRISE RISK MANAGEMENT (ERM)

Asset Liability Management

Underwriting/Risk Management

Operational /Risk Management

Mortality

Persistency

Policyholder Behavior

New Business/Renewals

Expenses

Claims

Taxes

Policy Loans

Severity

Interest rate Risk

Credit Risk

Liquidity Risk

Equity Risk

FX Risk

Fraud

Mismanagement

Legal/Compliance

Reputation

Regulatory

Administrative

Information Technology

Staffing

Marketing

ALM HELPS IMPROVE THE INVESTMENT PROCESS BY INTRODUCING DISCIPLINE, MEASURING BETS AND BALANCING RISKS WITHIN THE

PORTFOLIO See Important Disclosure Notes at End

3

ALM Contributes To An Organization’s Decision Making Framework

Key Metrics of ERM that ALM can help you manage:

How much risk is your firm taking?

Has your investment risk increased or decreased in the past three months?

Do you have the right amount of capital to support the risk you are taking?

Utilize ALM to identify strategies to reduce risk

Organization Management

ALM Framework

ALM is a process that helps assess, quantify and identify asset allocation that may be appropriate for a company’s unique liability structure and management’s risk profile

Asset allocation is a method of diversification which positions assets among major investment categories. This method may be used in an effort to manage risks and enhance returns. However, it does not guarantee a profit or protect against a loss.


Investment Strategy DesignUsing ALM as the Driver to Develop the Plan

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Establish Key Metrics/Objectives

• Interest rate Risk

• Credit Risk

• Liquidity Risk

Typical Financial Objectives Typical Risk Objectives

• Improve Portfolio Yield

• Minimize/Maximize Gains/losses

• Diversification

• Meet Regulatory/Guideline Constraints

• Rewarded For Risks In Portfolio

• Offset/balance natural exposures (ex annuities and whole life)

• Economic Value - Optimize on ALM/Contingent Surplus/Free Surplus. Develop Multiple Solutions

ALM is an ongoing process which requires continuousmonitoring of a firm’s exposures and financial results to augment the portfolio management process.


5

Process

Parametric IR Risk

Yiel

d

Purchase targets• $MM allocation• Generic or specific

assets

Liabilities Liabilities Optimization Engine

Tool for linear, efficient frontier, multi-objective and integer-

programming analysis

HoldingsHoldings

Security availabilitySecurity availability

“Sell” list• Security A• Security Z, etc.

IR Risk(parametric)

YieldRisk appetiteRisk appetite

Constraints:• Credit• Sourcing

Constraints:• Credit• Sourcing

• Cap.Gains• ALM

Assess rebalancing alternatives to help improve inforce asset mix versus current liabilities


6

Three Steps To Potential Success

Step 2 Step 3Step 1

Policy formulationApply tools to identify “prudent” strategies

Define performance metrics

• How do we measure business success?

• Return and risk measures• Simulation vs. analytic• Data for model calibration

• Portfolio risk/return profiling• Multi-factor decision model• Visualization for multi-

dimensional decisions• Scenario-based optimization

• Sensitivity analysis• Tactical

implementation is achievable

• Policy simulation

Time

The distribution of portfolio value at the horizon

Today Future

Time

The distribution of portfolio value at the horizon

Today Future


7

Our Method Starts with A Partial Duration View of a “Portfolio”

PeriodExisting 12/31/6

Liability 12/31/6

Proposed Portfolio 12/31/6

6-month 0.07 - 0.02 1-year 0.15 0.30 0.14 2-year 0.24 0.40 0.26 3-year 0.59 0.42 0.71 5-year 1.04 0.79 0.91 7-year 0.65 0.38 0.50 10-year 0.44 0.35 1.26 20-year 0.04 0.57 0.01 30-year 0.03 0.35 0.00

Total 3.23 3.56 3.81

12/31/6 Existing 12/31/6 Liability Proposed Portfolio 12/31/6

12/31/0612/31/0612/31/06

12/31/06 12/31/06 12/31/06

Source: GEAM, example of ALM position

This is a hypothetical example used for illustrative purposes only. The example does not represent or project the actual results of using ALM strategies described in this presentation.


8

Two Basic Approaches

“Portfolio Rebalancing”: Investigate mix of inforce assets to assess appropriate risk profile

• Parametric view of interest risk; VaR• As many portfolio constraints as desired• Optimize via Linear Programming, Sequential Linear Programming, or

Multiple-objective optimization• Multiple Scenario Option Capability• Current and future date view of performance

“Strategic”: Modify reinvestment or new-money investing• Scenario-based interest and liability risks• Same portfolio constraints as portfolio rebalancing • Nonlinear optimization• Investigate portfolio rebalancing decisions effect on current and future

surplus


9

“Liability Driven” Optimization Methodologies

Level 3

Add detailed callable models

Explicit Cash Flow Projections for Callable Bonds /Structured Products• Pull From BONDEDGE or INTEX Projection Systems• Generally, Most Appropriate for Highly Interest-sensitive Asset

and Liability Cash Flows

Level 2

Add interest-rate scenarios

Deterministic (like NY7) or Stochastic Rate Scenarios• Project Corresponding Changes in A/L Valuation• Evaluate Impacts on Future Surplus Development• Position for Economic Gain; Control Surplus Volatility & Worst-

case Loss• Generally, Most Appropriate for Interest-sensitive Liability

Cash Flows

Incrdet

easingail

Level 1

Parametric interest-rate assumptions

“Sequential Linear Programming”• Projected Liability Cash Flows; Historical Rate Trends• Improve Projected Book Yield; Reduce Standard Deviation• Generally, Most Appropriate for Non-interest Sensitive A/L

Cash Flows


10

• Optimization results need to be reviewed & confirmed by client:

- Risk/return trade-offs along Efficient Frontier

- Impact of chosen constraints

- Interest rate scenarios

- Quantify impact of proposed changes

Depending on discussion results, optimization may be re-run - Typically process is iterative

• A good optimization process can produce viable alternatives that can be modeled to improve upon specified business objectives.

Policy


11

Keep Insurance Context In Focus

ALM is an ongoing process. Continuous monitoring of exposure and financial results helps to augment the portfolio management process.

GEAM’s PROFITS application seeks to deliver this service while striving to meet the objectives of the client

− Regulatory: Risk-Based Capital Requirements

− Accounting: Minimize realized gains/losses

− Diversification constraints

− Risk: Duration/Credit/Asset Class/Interest Rate


12

Potential Rewards of ALM Work Done Well

- Better Bottom Line Result from Asset Portfolio w/o taking on Greater Risk

- Develop Better Balance Between Short-term and Long-Term Financial Goals

- Manage, or Smooth Out Income Volatility

- Determine Which Risks To Take or Avoid Within Portfolio

- Traditional Management of Assets Based On Accounting Rules May Cause Companies To End Up Mismatching Liabilities, While Attention To ALM Can Help Them Achieve Their Financial Objectives


13

Set Investment Constraints To Conform To Managements Risk ProfileCredit

Standard credit constraints•Average Credit Rating Min/Max, dollar-weighted•Average Risk Based Capital Min/Max, dollar-weighted•Concentration Limits e.g. 5% BB, 45% BBB•Use Net Yield (versus Gross) Maximize yield per unit of risk •Average Default Charge Min/Max, dollar-weighted across portfolio•Sector/Issuer limits If data available, can constrain by industry sector or

other breakdown

Interest-Rate Risk•Effective Duration Mismatch Min/Max on aggregate mismatch (all assets

versus liabilities)•Partial Duration Mismatches Min/Max on each individual duration component•Effective Convexity Mismatch Min/Max on aggregate mismatch•Standard Deviation Short-term measure of surplus-value volatility

(standard deviation) due to Interest Rates•Value at Risk Short-term measure of surplus-value loss

potential due to Interest Rates movements


14

Set Investment Constraints To Conform To Managements Risk Profile

Sourcing/Trading•Aggregate Turnover Min/Max on $ value (or percent) of holdings which may

be traded•Asset-class limits Min/Max on CMBS, High Yield, etc., allowed within

“final” portfolio•Per-asset limits Min/Max on individual buy-assets, e.g. 10-year BBB-

rated CMBS•Liquidity restrictions Prevent sale of specific holdings

Other Constraints•Capital gains Min/Max on realized gains resulting from

recommended sales•Target portfolio size Force purchase or sale of securities in order to change

aggregate portfolio value


15

Book Yield (%)

Projected Yield Improvement

(bps)

Effective Duration of Assets

(years)

Effective Duration

of Liabilities

(years)

Duration Mismatch

(years)

12/31/06 Exisiting Portfolio 6.29 - 7.19 15.19 8.00

1 6.55 26.40 8.81 15.19 6.38 2 6.55 26.00 9.00 15.19 6.19 3 6.54 25.00 9.26 15.19 5.94 4 6.52 23.30 9.59 15.19 5.60 5 6.44 15.40 9.85 15.19 5.34 6 6.25 (3.40) 10.05 15.19 5.14

Strategic assessment of portfolio alternatives from multiple view points including:

• Portfolio statistics (duration, yield, capital gain or loss)

Output

See Important Disclosure Notes at EndThis is a hypothetical example used for illustrative purposes only. The example does not represent or project the actual results of using ALM strategies described in this presentation.

Asset Type Amount sold

($millions) Average duration

(years) Average Yield

(%) Capital

Gain/Loss ($)

ABS 4.64 0.71 5.82 (0.07)AGENCY 13.26 1.82 5.15 (0.31)

CMBS 11.61 3.80 5.68 (0.04)INV GRADE 77.87 2.55 5.48 (2.23)

MUNI 8.66 9.09 6.46 2.65

Total 116.04 3.01 5.55 (0.00)

16

Output

Strategic assessment of portfolio alternatives from multiple view points including:

• Portfolio Composition (Credit, Security Type)



17

Attribution Analysis

– Evaluate impacts of changes in maturity, credit, asset selection– Drill down to impact per asset type

12 bps

-3 bps

20 bps5 bps

Overview level: Impact of a shift in...

Maturity breakdown

Credit breakdown

Asset class breakdown

Other

Detail level: Impact per asset class, per cause Maturity Credit Allocation

Sell -other

Buy -other

Inv GradePrivates

ABSCMBS

MBS

Baseline Portfolio

Yield

5.34%

Optimized Portfolio

Yield

5.68%

Duration & credit haven’t changed... so 34 bps from where?



18

Disclosure NotesDisclosure Notes

PROFITS is a GE Asset Management (“GEAM”) proprietary investment tool which assists in developing potential investment portfolios based on specific client requirements. PROFITS suggests multiple portfolios which lie along an efficient investment frontier and which are based on a variety of inputs. Many of these inputs are provided by a client and all incorporate GEAM’s assumptions regarding future events. The efficient frontier (“EF”) utilized by PROFITS is comprised of certain fixed income asset classes which would typically be appropriate for core insurance investors and such frontier does not therefore include the universe of assets which could be included within a more theoretical efficient frontier. PROFITS output is dependent upon hypothetical analysis of historic returns, volatility and many other factors. Past performance is not always an accurate predictor of the future and reliance on historical data is inherently limited.

There is a risk of loss from investment in securities. The ALM strategies described in this presentation incorporate assumptions regarding future events, GEAM makes no representation or warranty regarding the future performance of any portfolio managed by GEAM and noinference to the contrary should be made.

The term “Optimization” used throughout the presentation is intended solely to reflect the multiple portfolios which lie along the EF and no guarantee is provided (nor should any guarantee be inferred) regarding the risk or return or other investment characteristics which would be experienced by any GEAM managed portfolio.

Because the ALM strategies described incorporate dynamic and variable data as of a certain point in time, reliability may be further compromised by any future events or changes to such inputs. Any and all successive “runnings” of the methodology (i.e., through the PROFITS tool) would be solely at the mutual determination of the client and GEAM.

Nothing presented herein is, or is intended to constitute, investment advice, nor sales material and no investment decision should be made based on any information provided herein. Information provided reflects GEAM’s views as of a particular time. Such views are subject to change at any point without notice.

While GEAM uses reasonable efforts to obtain information from reliable sources, GEAM makes no representations or warranties as to the accuracy, reliability or completeness of any third party produced information presented herein.

Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.

Investments cited may not represent current or future holdings and nothing presented should be construed as a recommendation to purchase or sell a particular investment or follow any investment technique or strategy.

The information provided is confidential and shall not be copied or distributed.

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