Principles Underlying Asset Liability Management
The Society of Actuaries Board of Governors has approved
the following document: "Principles Underlying Asset Liability Management"
for release as an exposure draft to the members of the Society of
Actuaries, other actuarial organizations and various interested parties
outside of the actuarial profession.
The Task Force on Asset Liability Management Principles
welcomes your comments. In your comments, please include a clear
reference to each section of the document you are commenting on (i.e.
II. Definitions, C. Portfolio: Comments). All comments received on or
before January 31, 2005 will be considered and a final Principles document
will be issued shortly thereafter.
Please send your comments to: firstname.lastname@example.org
Charles L. Gilbert, FSA, FCIA, CFA
of Actuaries Task Force on Asset Liability
PRINCIPLES UNDERLYING ASSET LIABILITY
October 12, 2004
Society of Actuaries. All rights reserved.
This document is provided
for educational purposes only and is not intended to cover every situation
that you may encounter or to represent the best or only approach to any
particular issue. The information presented here does not replace your
independent judgment and that of your company and/or employer. Neither the
Society of Actuaries nor the individuals or companies participating in the
ALM Principles Task Force make any guarantee with regard to the accuracy,
completeness or suitability of the information contained herein, and they
assume no responsibility or liability in connection with the use or misuse
of any such information. This document should not be construed as
professional or financial advice. The information presented herein does
not necessarily represent the opinions of the Society of Actuaries or its
officers, directors, staff or representatives.
TABLE OF CONTENTS
of ALM Principles
Principles Task Force
Steps of An ALM
the Entity's Risk/Reward
the Level of Risk
and Implement Strategies to Modify Existing
Risk Exposures and Revise ALM Strategies as Appropriate
- PRINCIPLES AND STANDARDS
The practice of any profession is
shaped by the experience of its members as well as by accumulated
scientific knowledge. The practice of the actuarial profession is
based on principles and standards.
Principles abstract the key elements of the scientific
framework. Principles are not prescriptions that specify how actuarial
work is to be done, but are statements grounded in observation and
experience. As our experience and understanding continues to develop,
the articulation of these principles may change.
In addition to principles, the actuarial profession requires
standards. Standards are normative rules, based on the state
of the art and science of actuarial practice, regulatory constraints,
and other external conditions. They guide the actuary in the selection
of appropriate models and assumptions. Standards are subject to change
and new standards will be introduced as actuarial practice evolves.
This document is not intended to set forth standards.
Principles may be categorized as general or
practice-specific. The principles discussed herein are specific
to the Asset Liability Management (“ALM”) area of practice.
- APPLICABILITY OF ALM PRINCIPLES
A wide variety of entities are
faced with ALM related considerations. Such entities include:
- Insurance companies, banks and thrifts, investment firms, and
other financial services
- Pension and trust funds (e.g., endowments and foundations)
- Other commercial or not-for-profit enterprises
- Individual investors
- ALM PRINCIPLES TASK FORCE
The Task Force was comprised of
members of the actuarial profession with experience in ALM in the
United States and Canada. The ALM principles articulated in this
document are applicable to a broad range of entities facing
ALM-related issues. The applicability of these principles will depend
on the relevant context and circumstances of each such entity.
Although the principles herein are intended to cover a broad range of
topics and issues, there may be other factors not discussed here, and
some of the definitions may be interpreted differently based on the
context of a particular industry under the consideration. Whenever
possible, the document attempts to capture these differences, such as
in the case of pension plans and trust funds. However, independent
professional judgment must be exercised in all situations.
Since the early work of Frank M. Redington in the 1950s,
actuaries have applied actuarial techniques and skills to ALM for
insurance companies, pension funds, investment firms, and other
financial institutions. To recognize this contribution, the Society of
Actuaries’ Finance Practice Area Advancement Committee formed the
Asset Liability Management Principles Task Force (“Task Force”), with
the charge to identify and articulate the principles of
The original Task Force was formed in 1996 and distributed
an initial draft ALM Principles document in 1998. At that time, there
existed divergent views on the central principle of ALM – economic
value. Financial industry practice at the time placed greater
importance on accounting results rather than economic value, and this
issue was debated at length. Much has happened since 1998. Equity
analysts and rating agencies began calling for a more meaningful way
to value companies than the traditional accounting measures.
Internationally, pressure mounted to move to fair value-based
accounting standards. Accounting scandals shed new light on how easily
accounting earnings could be manipulated and the emergence of earnings
distorted. The importance of focusing on economic value was no longer
a theoretical argument. A revitalized Task Force took up the call to
finalize the ALM Principles document in the Spring of 2003 and
unanimously recognized economic value as the central principle of ALM.
This document incorporates changes the Task Force considered
appropriate based on the many comments received in response to the
original exposure draft.
While specific considerations and
methodology used to in implementing ALM may differ between insurance
companies, private pension plans, public pension plans and social
insurance systems, the principles articulated in this document broadly
apply to all entities.
Current members of the Task Force are:
Charles L. Gilbert, Chairperson
Charles V. Ford
Frederick W. Jackson
Emily K. Kessler
Josephine E. Marks
Catherine G. Reimer
Albert V. Sekac
Peter D. Tilley
SOA Finance Practice Actuary: Valentina Isakina
We would also like to acknowledge Michael A. Hughes (Past
Chairperson), Cindy Forbes, Joseph M. Rafson, and Joseph Tan for their
contributions to the early work of the task force.
This report represents the findings and conclusions of the Task
The selection criterion for definitions included in
this section was their ability to enhance the interpretation of the
Principles Underlying Asset Liability Management document
(“Principles”). The definitions appear in a logical order considered
most appropriate for the enhanced understanding of the
Many terms used in the Principles assume a working
knowledge of actuarial science, particularly as applied to risk
management and finance. The reader is referred to the “Principles
Underlying Actuarial Science” statement of the Society of Actuaries for
- ASSET LIABILITY MANAGEMENT
Asset Liability Management
is the ongoing process of formulating, implementing, monitoring, and
revising strategies related to assets and liabilities to achieve
financial objectives, for a given set of risk tolerances and
ALM is critical for the sound financial management
of any entity that invests to meet future cash flow needs within
constraints. ALM is broader than risk mitigation1 and is
inextricably linked to the liability and investment management
ALM is a vital element within an
Enterprise Risk Management framework. Some companies use ALM as part
of a strategic decision-making framework to exploit opportunities to
create value and optimize their risk/reward
The desirability of applying ALM and the
chosen ALM process will vary from entity to entity due to
case-specific circumstances and preferences of each entity. The
importance of ALM to an entity that focuses on managing risks for
profit, and the sophistication of its ALM process, is different than
that of an entity that has other sources of revenue. A general
outline of the fundamental steps in an ALM process is provided in
Entity is defined in the
Principles to include an organization, pension plan, portfolio, and
Sometimes the entity at risk and responsible
organization are different. There are often multiple
organizations/individuals with an interest in the entity, e.g.,
state regulators, individuals doing business with the entity, but
only one organization bears the primary risk, as well as legal and
fiscal responsibility. For insurance companies there is generally no
difference between the entity at risk and responsible organization.
For other entities, these might be different. For example, the
pension plan is an entity for which the plan sponsor has
responsibility, but which is legally separate and managed in
addition to the core business of the organization. The entity at
risk is generally the plan but the entity bearing the risk is
generally the plan sponsor, who must weigh the risks generated by
the plan against other enterprise risks.
A portfolio is a collection
of assets, liabilities or both.
A portfolio may consist of a single asset or
liability. Only financial assets and liabilities are considered in
An (financial) asset is cash
held or the right to receive cash, possibly contingent on a
predetermined event, at future times.
Some assets, such as derivatives, may have both asset
and liability characteristics.
A (financial) liability is
an obligation to pay cash, possibly contingent on a predetermined
event, now or in the future.
- ENTERPRISE RISK MANAGEMENT
Management (“ERM”) is the discipline by which an entity in any
industry assesses, controls, measures, exploits, finances, and
monitors risks from all sources for the purpose of increasing the
entity’s short- and long-term value to its stakeholders (based on the
ERM definition from the Casualty Actuarial Society Advisory Committee
on Enterprise Risk Management, May 2003 Report).
ALM is an integral part of ERM.
Risk is the exposure to an
uncertain event or outcome that has a financial impact to which the
entity is not indifferent.
For insurance and other financial institutions, risk
is inherent in doing business. Risk captures the possibility of
positive and negative deviations from an expected outcome. Financial
institutions and other entities may be exposed to many different
types of risks, which can broadly be categorized as credit, market,
operational, and insurance/underwriting risks.
private pension plans, risk is often considered in light of the plan
sponsor’s business plan. Financial results of pension plans are
generally components of the plan sponsor’s overall results. In some
cases, the plan may account for a significant portion of the plan
sponsor’s results; in other cases, the pension plan may be
relatively insignificant. Risk can also be separately considered for
shareholders, plan participants, and any guaranty agencies.
- RISK TOLERANCES
Risk tolerance of an entity
is a degree of preference for a particular risk over a stated
Risk tolerances may be translated into risk limits
that set the maximum allowable exposure (e.g., the maximum loss for
a given confidence level, or the maximum change in economic value
for a given change in a financial variable).
private pension plans, the risk tolerance considered is generally
that of the plan sponsor. The plan sponsor’s risk tolerance is
influenced by regulatory and fiduciary constraints.
restrictions on the set of strategies that may be incorporated into an
Constraints may be either external or internal.
External constraints include regulatory requirements, tax laws, and
other legislative requirements. Internal constraints reflect
management philosophy or professional judgment (such as asset
allocation limits), which may be influenced by rating agencies,
regulators, customers, and other stakeholders.
- FINANCIAL OBJECTIVES
are the key financial priorities and goals for an entity.
In an entity, financial objectives are generally
determined by senior management and the board of directors. The
financial objectives most appropriate to the ALM process usually
focus on the long-term best interests of the policyholders,
shareholders, and other stakeholders. Examples of financial
objectives include maximizing economic value and accounting
measures, including future net income, return on equity, statutory
surplus, or current year earnings. Financial objectives for pension
plans typically focus on the ability to cover obligations when due,
with acceptable level and volatility of contributions, pension
expense and funded levels.
- ECONOMIC VALUE
represents the long-term inherent value of the portfolio.
Economic value is based on the portfolio’s future
cash flows, as distinguished from values based on a specific
accounting framework or funding requirements. Funding requirements
and accounting-based values serve as a constraint on future cash
- ACCOUNTING VALUE
An accounting value
for a portfolio is the net value assigned to the portfolio by a
financial accounting system.
An accounting value may be an economic value, but
often involves non-economic considerations and conventions that act
as constraints. The International Accounting Standards Board defines
a financial accounting system as a system that provides guidance to
the recognition and measurement of financial values used for
presentation in a financial statement. Several different financial
accounting systems are in use.
A scenario is a possible
future state of the world.
Scenarios are chosen to represent the possible
future states of the world relevant to managing portfolios of assets
and/or liabilities. The set of scenarios may represent the possible
future values of financial instruments, such as bonds and stocks,
inflation, term structure, credit spreads, ratings changes or
defaults, or the possible set of survivors from an initial group of
The degree of correlation
between two portfolios relative to a set of scenarios is a measure
reflecting the relative variation of the economic values of the
portfolios over the set of scenarios.
Two portfolios are said to be 100% positively
correlated relative to a set of scenarios if the ratio of the
economic values of the two portfolios is the same in each scenario
in the set at each time period. Linear relationships between
variables are often assumed in finance and economics but true
interdependencies may be considerably more complex.
- NON-SYSTEMATIC RISK
risk is risk that can be reduced or eliminated by aggregation of
entities that are less than 100% positively correlated with respect to
a given risk factor.
Non-systematic risk is also known as diversifiable
risk or specific risk.
- SYSTEMATIC RISK
Systematic risk is the
residual risk that cannot be eliminated by aggregation or pooling of
the same risk within a given market.
Systematic risk is also known as non-diversifiable
risk or market risk. It may be reduced by hedging.
Hedging is the technique of
designing a portfolio with cash flows that offset or defease another
portfolio’s cash flows in certain scenarios.
After hedging, the entity’s risk profile is more
aligned with the entity’s risk tolerance. This technique allows the
entity to become less concerned with which future scenario
- ECONOMIC VALUE
ALM focuses on Economic Value.
A consistent ALM structure can only be achieved for
economic objectives. Economic value is based on future asset and
liability cash flows. ALM uses these future cash flows to determine
the risk exposure and achieve the financial objectives of an
An entity’s financial objectives may include
maximizing one or more of these values: economic value, accounting
measures such as earnings and return on equity, or embedded value.
For private pension plans, financial objectives may include the
pattern of future funding requirements. Various accounting measures
are affected by rules that change the emergence of income and the
reported book value of the assets and liabilities. These measures
can sometimes distort economic reality and produce results
inconsistent with economic value. Because ALM is concerned with the
future asset and liability cash flows, the natural focus of ALM is
economic value. Accounting measures or future funding requirements
are often included as constraints within an ALM
Entities that focus on economic value
tend to achieve their financial objectives more consistently in the
- MUTUAL DEPENDENCE
Liabilities and their
associated assets are mutually dependent.
Mutual dependence arises in an ALM context because
of the necessity to manage the interdependence between the asset and
liability cash flows to achieve economic and financial objectives.
The mutual dependence principle applies to portfolios consisting of
both assets and liabilities. It holds even if the assets and
liabilities are affected by different economic factors, or even if
asset and liability cash flows are fixed.
dependence may be greater when the performance of one portfolio
affects the performance of another portfolio. For example, the
credited rate on the liabilities may influence the lapse/withdrawal
rate, which in turn may require unexpected liquidation or
reinvestment of assets.
The mutual dependence
principle implies that assets and liabilities must be managed
concurrently in order to optimize achievement of economic and
The level of risk associated
with a given financial objective can be reduced through
diversification by combining exposures that are less than 100%
Risks are diversifiable through aggregation up to
the point where only systematic risk remains. For example, the
return volatility of a portfolio of assets caused by changes to the
level of prevailing interest rates is diversifiable through
investing in different asset classes such as stocks. However, the
residual systematic risk cannot be diversified through simple
aggregation. It can, however, be reduced through hedging.
times of significant economic turmoil asset correlations tend toward
1.0 or – 1.0. This can be observed in equity market data from
October 1987 or bond market data from August 1998. During such
environments the risk reduction benefits of diversification may
temporarily disappear. Correlations between asset returns may not be
a constant function, but instead may vary over time and between
different scenarios. Moreover, true relationships between variables
may be nonlinear.
The diversification principle applies to
all combinations of asset and liability portfolios.
- RISK/REWARD TRADE-OFF
Greater rewards are
generally expected from portfolios with higher levels of risk.
Rational investors2 expect greater
rewards for accepting higher levels of risk. The
higher-risk/greater-reward relationship may not hold if the
portfolio is sub-optimal for a given level of risk (i.e., a
comparably risky portfolio has a higher return); if an arbitrage
opportunity exists in the markets, or if environmental pressures
affect investors’ preferences and behaviors. As a direct result of
the risks accepted, greater reward commensurate with higher risk
levels may not be actually realized.
In an ALM context, the
riskiness of a portfolio is determined by the net position of the
combined assets and liabilities.
Expected risk/reward trade-off
tends to worsen as more constraints are imposed and as the constraints
become more restrictive.
An ALM framework contains internal and external
constraints including investment policy requirements, rating agency
expectations, regulatory issues, and required capital goals. For
example, an investment policy may specify that no below investment
grade bonds may be purchased and bonds downgraded to below
investment grade must be sold within 30 days. This constraint forces
a sale at a time when a bond’s price is under short-term pressure
and may offer an opportunity to investors not subject to this
Another common example of constraints within an
ALM context is the professional judgment constraints applied to
outcomes generated by mathematical models. For example, traditional
efficient frontier analysis is extremely sensitive to input
assumptions, and slight adjustments to assumptions can produce very
different efficient portfolio outcomes. Professional judgment is
typically applied to temper the model’s outcomes by constraining
asset class allocations and forcing additional portfolio
- DYNAMIC ENVIRONMENT
The risks to which an
entity is exposed and the associated rewards are determined by
internal and external factors that change over time.
ALM is an ongoing process. Risks an entity assumes
and to which it is exposed are continuously changing. Internal
factors arise from the financial objectives, risk tolerances, and
constraints of the entity. External factors include interest rates,
equity returns, competition, the legal environment, regulatory
requirements, and tax constraints. Such factors often impact both
assets and liabilities simultaneously, although the impact is not
necessarily of the same magnitude or in the same direction.
Furthermore, an entity may have different risk tolerances under
different circumstances and for different time horizons.
Accordingly, analyses, conclusions, and strategies relevant to a
specific point in time need to be periodically reevaluated and
Asset and liability cash flows
cannot be projected with certainty.
The dynamic environment as well as pure randomness
create uncertainties in the portfolio cash flows and, hence, in the
true risk exposure. Risk varies as the underlying risk factors
(e.g., interest rates, equity returns, defaults,
policyholder/customer behavior, lapses/withdrawals, pension
shutdowns, etc.) change and as future expected cash flows are
replaced by actual cash flows. This process reflects cash flows
reacting to factor changes (e.g., interest-sensitive cash flows),
truing up to actual experience, and results in revisions of future
assumptions. The ultimate risk exposure will be a function of the
actual cash flows.
ALM requires the use of models to
project future uncertain cash flows. In some cases, simple
deterministic models can be used and ALM can be based on one set of
expected future cash flows. In other cases, such as when future cash
flows are expected to depend on future economic conditions, more
complex models may be required to understand the interaction of the
asset and liability cash flows.
are often used to simulate future expected cash flows under various
scenarios to help identify the associated risk exposures. These
models produce statistical distributions of potential results and
different ALM strategies can be evaluated by studying the range of
results produced from modeling these strategies. Modeling can also
be used to construct many possible futures or scenarios, and then,
results across all the scenarios can be used to measure risk in the
Model risk is the additional risk created
when the model does not adequately represent the underlying process
or reality. There are two general classes of model risk: the risk of
model misspecification, oversimplification, or outright errors, and
the risk of a changing environment not anticipated in the model. For
example, using a lognormal model of stock market prices produces a
distribution with too few extreme value sample points (i.e., that is
not “fat” enough in the tails) to adequately assess the risk for
some complex embedded options, such as guaranteed minimum death
benefits. In addition, the volatility of equity returns varies over
time and this may not be accurately captured in the
The overall risk of a portfolio may be
reduced through hedging.
Hedging plays an integral role in the ALM process.
Once the risks associated with a portfolio or transaction have been
identified, the existing risks can be modified to suit the entity’s
risk tolerances and financial objectives. Undertaking additional
risks that partially or fully offset the existing risks may
accomplish this goal.
Hedging may be done at either
the transaction or portfolio level. Hedging may be complete or
partial, perfect or imperfect (i.e., cross hedging). Hedging
instruments include assets, liabilities, and derivatives. An asset
with a matching liability is a natural hedge. The time horizon over
which the hedge is in place may vary, but should nevertheless be
Risk can be controlled through
diversification when the law of large numbers applies (e.g., when
risks are diversifiable). Hedging is a strategy available to reduce
risk when the law of large numbers does not operate, such as when a
stock market decline results in equity-linked guarantees of an
annuity block of business being in the money for every annuity
contract at the same time.
Hedging may reduce some
risks but often introduces other risks, such as counterparty risk
and basis risk. Basis risk arises from imperfect or partial hedging,
where the hedging instruments are not perfectly negatively
correlated with the risks being hedged. In some instances, an
imperfect hedge may even increase the overall
As the overall risk is reduced through
hedging, the expected reward normally decreases as
- ECONOMIC VALUE
For a pension plan, economic value is the value of
plan surplus taking into account the level of contributions required
to achieve that surplus.
In practice many entities
do not focus on economic value and focus instead on accounting
earnings. Accounting results are relevant for many reasons: they are
reported to regulators, shareholders, and to the public; they may be
the basis for measuring management’s performance and have other
However, ALM is internally consistent only if
it is based on economic value. All of the traditional risk metrics
(duration, convexity, VaR, CTE or TailVaR, key rate sensitivity
analysis, etc.) focus on the asset and liability cash flows for the
purpose of measuring the exposure of economic surplus to changes in
If an entity is not concerned
with economic value, it does not need ALM. However, many entities
who have managed their assets and liabilities based on the
accounting treatment ended up mismatching their assets and
liabilities and ultimately failed.
Today, there are
still companies that do not focus on the economic value and permit
unrewarded mismatches on an economic value basis. These mismatches
are not to be confused with accounting asset and liability
mismatches, which may actually be naturally occurring in
- FUNDAMENTAL STEPS OF AN ALM PROCESS
effective ALM process begins with the support of the entity’s senior
management. Ongoing communication is essential. The process consists
of five fundamental steps:
- ASSESS THE ENTITY’S RISK/REWARD OBJECTIVES
The purpose of
ALM is not necessarily to eliminate or even minimize risk. The
level of risk will vary with the return requirement and entity’s
objectives. Financial objectives and risk tolerances are generally
determined by senior management of an entity and are reviewed from
time to time.
- IDENTIFY RISKS
All sources of risk are identified for all
assets and liabilities. Risks are broken down into their component
pieces and the underlying causes of each component are assessed.
Relationships of various risks to each other and/or to external
factors are also identified.
- QUANTIFY THE LEVEL OF RISK EXPOSURE
Risk exposure can be
quantified 1) relative to changes in the component pieces, 2) as a
maximum expected loss for a given confidence interval in a given set
of scenarios, or 3) by the distribution of outcomes for a given set
of simulated scenarios for the component piece over time. Regular
measurement and monitoring of the risk exposure is required.
- FORMULATE AND IMPLEMENT STRATEGIES TO MODIFY EXISTING
ALM strategies comprise both pure risk mitigation and
optimization of the risk/reward tradeoff. Risk mitigation can be
accomplished by modifying existing risks through techniques such as
diversification, hedging, and portfolio rebalancing. For a given
risk tolerance level, a given set of investment opportunities, and a
given set of constraints, optimization ensures that the portfolio
has the most desirable risk/reward tradeoff. Optimization
presupposes that the management team has been previously educated on
the risk/reward profile of the business and understands the
necessity to take action based on ALM analysis. Practitioners are
cautioned not to put undue reliance on the results of a mechanical
calculation. Professional judgment is an important part of the
- MONITOR RISK EXPOSURES AND REVISE ALM STRATEGIES AS
ALM is a continual process. All identified risk
exposures are monitored and reported to senior management on a
regular basis. If a risk exposure exceeds its approved limit,
corrective actions are taken to reduce the risk exposure. For
pension plans, monitoring current financial status and possible
short-term outcomes is very helpful in managing pension risk.
Operating within a dynamic environment, as the entity’s risk
tolerances and financial objectives change, the existing ALM
strategies may no longer be appropriate. Hence, these strategies
need to be periodically reviewed and modified. A formal, documented
communication process is particularly important in this step.
1 “Risk mitigation” seeks to
eliminate or reduce exposure to financial risk. “Risk management”,
on the other hand, does not necessarily seek to eliminate or even reduce
2 Behavioral economics uses
investor psychology to offer explanations when investors do not act