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Asset and Liability Dynamics

Asset and Liability Dynamics. Dynamic Financial Analysis CAS Special Interest Seminar July 19 - 20, 1999 Elissa M. Sirovatka, FCAS, MAAA Tillinghast - Towers Perrin. Overview. Asset modeling process Existing assets Future assets Investment strategies

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Asset and Liability Dynamics

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  1. Asset and Liability Dynamics Dynamic Financial Analysis CAS Special Interest Seminar July 19 - 20, 1999 Elissa M. Sirovatka, FCAS, MAAA Tillinghast - Towers Perrin

  2. Overview • Asset modeling process • Existing assets • Future assets • Investment strategies • Interrelation of asset and liability dynamics • Real life uses

  3. Asset Modeling Process Investment Strategies Existing Assets Economic Scenarios Future Assets Liability Cash Flows Dynamic Model Asset/Liability Cash Flows

  4. Existing Assets - PC Industry • Bonds - 65.0% • Equities - 25.0% • Cash - 5.0% • Real Estate, Mortgages, and CMOs - 5.0%

  5. Fixed rate coupon - rate fixed through maturity Adjustable rate coupon - rate periodically reset based on market rates Zero coupon - no coupon,sold at deep discount Sinking fund - par value repaid according to fund schedule Tax status - all or part of coupon payment tax exempt ? Callable - borrower may prepay principal at specified premium Putable - investor has option to demand discounted prepayment Existing Assets - Bond Types

  6. Quality -Treasury, AAA, AA, junk Maturity date Value - book, par, and market Coupon - rate and frequency Issue year Planned date of sale Call/Put info - year, premium/discount Sinking fund info Tax status Investment expenses Existing Assets - Bond Characteristics

  7. Sector - Large cap, small cap, international Market value Actual cost Relationship of market value to market value index Relationship of dividend yield to dividend yield index Dividend frequency Investment expenses Existing Assets - EquityCharacteristics

  8. Existing Assets - Cash Account • Establish at start of model • Select a relationship to point on yield curve

  9. Relationshipof Asset Yields to Economic Scenarios (Yield x M) + S Yield = Scenario generated yield rate for a point on yield curve M = Multiplier S = Spread

  10. Future Assets - Asset Groups Select asset groups for future investment with common characteristics: • Quality - affects relationship of asset returns to scenario generated yield curve and default rates • Types - sinking fund bonds, common stock, callable bonds, etc. • Duration - for purchasing and selling • Assign to existing assets as well

  11. Investment Strategy • Uses asset groups • Purchase/sell assets • Determine allocation between asset groups • Cash based • Book value based • Apply different strategies in different situations

  12. Investment Strategy - Calendar Period • Strategy applies for a given period of time • Allows you to change asset mix over time • Example: • Beginning asset mix: 80% bonds, 5% equities, and 15% cash • Move towards industry: 65% bonds, 25% equities, 5% other invested, and 5% cash • Strategy varies by year over first four years and then stabilizes at desired allocation

  13. Investment Strategy - Calendar Period

  14. Investment Strategy - Special Situation • Overrides calendar period strategy if a special situation occurs • High interest rates • Allocate a greater portion of total assets to bonds • Invest in long-term bonds to lock in higher coupon rates • Low interest rates • Allocate a greater portion of total assets to equities • Invest in short-term bonds rather than long-term • Inverted yield curve • Invest in short-term bonds to get high rate with lower risk

  15. Investment Strategy - Negative Cash Flow • Reduce cash to minimum amount • Alternatives: • Borrow funds • can borrow up to a maximum amount • interest rate is based on 90-day yield rate, plus spread • Purchase negative assets • can purchase up to a maximum amount • proxy for borrowing assets from another asset segment of the company • Sell assets • according to sales classification/priority assigned at model start

  16. Interrelation ofAsset and Liability Dynamics • Economic conditions directly affect asset results through • varying asset default rates, floating interest rates, and changing market values • exercise of call, put and prepayment options

  17. Interrelation of Asset and Liability Dynamics • Economic conditions directly affect liability results through • inflation affects • amount of loss and ALAE • future written premium affected by inflation • fixed expenses • if discounting loss reserves, discount rate may be affected by scenario generated yield curve

  18. Real Life Uses • Deterministic Scenarios • Used to investigate the behavior of results during specific assumed future economic conditions • Stochastic Scenarios • Used to investigate the range of possible future economic conditions which cannot be predicted with certainty

  19. Real Life Uses • Cash Flow Testing • Measures adequacy of asset held for a company or a block of business. Can set existing assets equal to initial liabilities • Distribution of Results • Range of asset/liability results using stochastic scenarios can show the volatility and risks involved in a company or block of business. Can test alternative investment portfolios, underwriting strategies and reinsurance programs

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