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ASOSIASI KONSULTAN AKTUARIA INDONESIA
TrainingTraining 2 2 HariHariPenerapanPenerapan SPERIS SPERIS dandan SANBERRISSANBERRIS
Dana Dana PensiunPensiun
AssetAsset--Liability ManagementLiability Management::An IntroductionAn Introduction
Redtop Hotel, Jakarta, Juni 2008 – April 2009
22Penerapan SPERIS dan SANBERRIS Dana Pensiun
ContentsContents
1212--1414Monte Carlo SimulationMonte Carlo Simulation55
1515--1818Steps to ALM ProcessSteps to ALM Process66
1919--2323Understanding Simple ModelUnderstanding Simple Model77
88--1111ALM for Pension FundsALM for Pension Funds44
77Role of ActuaryRole of Actuary33
2424--3838Basic MetricsBasic Metrics88
44--66What is ALM?What is ALM?22
33IntroductionIntroduction11
ContentsContents PagePageSectionSection
33Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 1SECTION 1
u Corporate and individual financial systems are supported by a cash flow balancing (matching) activitiesn Savings for child education: savings are assets to be invested and
future payment of school fees are liabilitiesn Pension plan: contributions are assets invested to meet pension
payments (liabilities) at future dates
u Matching activities of cash flows of financial planning is called Asset-Liability Management (ALM)
GeneralGeneral
IntroductionIntroduction
44Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 2SECTION 2
u ALM is the practice of managing business so that decisions taken with respect to assets and liabilities are coordinated
u ALM can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve financial objectives, giventhe risk tolerance and other constraints
u Traditional ALM focuses primarily on the risks associated with changes in interest raten Current ALM considers much broader range of risks: equity,
liquidity, currency and sovereign/country
GeneralGeneral
What is ALM?What is ALM?
55Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 2 SECTION 2 (continued)
u Discrepancies between assets and liabilities do exist when volume and timing are concernedn Some assets may be short term but liabilities are long term
u Perfect match is not always possible
GeneralGeneral
What is ALM?What is ALM?
66Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 2 SECTION 2 (continued)
u Application of ALM techniques in diverse setingsn Derivative dealers manage their long and short positionsn Bankers coordinate the repricing horizons of their assets and liabilitiesn Pension plans adjust their investments to mirror the characteristivs of
their liabilities with respect to interest rates, equity returns and expected changes in wages
n Insurers select investment strategies to ensure they can suportcompetitive pricing and interest crediting strategies
ApplicationApplication
What is ALM?What is ALM?
77Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 3SECTION 3
u Actuaries measure, model and manage risk
u Actuaries must have knowledge and understanding of assets and liabilities and how they are interrelatedn The operation of financial marketsn The available instrumentsn The risks inherent in any particular business to enhance profitability and
solvency
u The coordination of product development, investment operations and financial reporting is essential for a succesful financial security systemn Actuaries are well prepared through education and experience to perform
this role
Role of ActuaryRole of Actuary
88Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 4SECTION 4
u ALM for pension funds is a risk management approachn Takes into account assets, liabilities, interaction between different
policies to apply
u Board should find acceptable policies that guarantee that the solvency of the fund is sufficient during the planning horizon and at the same time all promised benefit payments will be made
u Solvency is the ability to fulfill all promised payments in the long runn Solvency at a certain time moment is measured as the funding ratio
u Funding ratio changes over time – fluctuations in the liabilities and assets – controlled by rebalancing asset portfolio and adjusting contributions
GeneralGeneral
ALM for Pension FundsALM for Pension Funds
99Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 4 SECTION 4 (continued)
u Conflicting interests of different parties exist in ALM decisionprocess
u At least 5 parties are involved in the decision making processn Active participantsn Retired persons and surviving relativesn Deferred membersn Sponsor of the fundn Supervisor of the fund
Interested parties in the policy of pension fundInterested parties in the policy of pension fund
ALM for Pension FundsALM for Pension Funds
1010Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 4 SECTION 4 (continued)
u Instruments to control funding ratio by taking into account the interested parties to obatain best policy mixn Pension policy – different types of pensions includedn Pension system – rules with respect to benefit paymentsn Indexing policy – consumer price index or a wage indexn Reinsurance policy – risks of decease or disabilityn Contribution policy – dynamic and can be changed over timen Investment policy – decision of assets classes, limitation in each assets
classes
Policies and Policies and intrumentsintruments
ALM for Pension FundsALM for Pension Funds
1111Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 4 SECTION 4 (continued)
u Pension funds are exposed to many sources of risksn Funding ratio is important in determining the financial soundness of a
fund and the greatest concerns is the risk of underfunding: the risk that the value of the liabilitiesis higher than the value of the assets
u Some of the many sources of risksn Risks regarding the asset portfolio – currency, default, volatilityn Actuarial risks – longevity risk, risk of short life, economic assumptionsn Risks with respect to contributions – contractual contributions need to be
paid when sponsor are in bad financial situationn Risks regarding reinsurance – risks of defaultn Risks with respect of indexing
u Risks may be reduced – broadly diversified portfolio for example
RisksRisks
ALM for Pension FundsALM for Pension Funds
1212Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 5SECTION 5
u Methodology created by Stanislaw Ulamn A scientist who worked on the Manhattan Project – forecasting possible
ranges and impacts of nuclear explosionsn Named after his uncle who liked to gamble at Monte Carlo
u Monte Carlo Simulationsn Describe range of investment results with a given investment allocationn Show the probability of achieving successful and unseccesful outcomesn Use randomly generated returns based on a protfolio’s risk and return
profile (historical or estimated standard deviation and expected return) to calculated thousands of potential portfolio values over a given period and sum all the probability of any of those outcomes
GeneralGeneral
Monte Carlo SimulationMonte Carlo Simulation
1313Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 5 SECTION 5 (continued)
u Monte Carlo Simulations include 3 critical factors that linear forecating may ignoren Compoundingn Cash flown Sequence of returns
u Compoundingn Linear forecasting uses arithmetic returns which ignores the effect of
compounding – uses simple averagen Geometric returns take into account of compoundingn See example
Critical factorsCritical factors
Monte Carlo SimulationMonte Carlo Simulation
1414Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 5 SECTION 5 (continued)
u Cash flown Average approach ignores the impact of cash flows in and out of a
portfolio – uses time-weighted rate-of-return (TWR) or “investment return”– ignores the impact created by the inflow of new money
n Instead uses dollar-weighted rate of return (DWR) or “investor return” –takes into account the timing of contributions and withdrawals
u Sequence of returnsn Sequence of returns may effect investorsn The order in which an investor encounters returns over time has a direct
effect on the terminal value of the portfolio
Critical factorsCritical factors
Monte Carlo SimulationMonte Carlo Simulation
1515Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 6SECTION 6
u An effective ALM process begins with the support of the managementn On going communication is essential
u The process consists of 5 fundamental stepsn Assess risk/reward objectivesn Identify risksn Quantify level of risk exposuren Formulate and implement strategies to modify existing risksn Monitor risk exposure and revise strategies as appropriate – continual
process
Fundamental stepsFundamental steps
Steps of ALM ProcessSteps of ALM Process
1616Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 6 SECTION 6 (continued)
u Assess risk/reward objectivesn Not necessarily to eliminate or even minimize riskn The level of risk will vary with the return requirements and objectivesn Determine objectives and risk tolerances and review from time to time
u Identify risksn Must identify all sources of risks for all assets and liabilitiesn Risks are broken down into their component pieces and the underlying
causes of each component are assessedn Relationship of various risks to each other and or to external factors are
also identified
Fundamental stepsFundamental steps
Steps of ALM ProcessSteps of ALM Process
1717Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 6 SECTION 6 (continued)
u Quantify level of risks exposuren Relative to changes in the component piecesn As a maximum expected loss for a given confidence interval in a given
set of scenariosn The distribution of outcomes for a given set of simulated scenarios for the
component piece over timen Regular measurement and monitoring of the risk exposure is required
u Formulate and implement strategies to modify existing risksn Mitigating risks by modifying existing risks through techniques such as
diversification and porfolio rebalancingn Optimization of the risk/reward tradeoff – tolerance, opportunities and
constraintsn Professional judgment is an important part of the process
Fundamental stepsFundamental steps
Steps of ALM ProcessSteps of ALM Process
1818Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 6 SECTION 6 (continued)
u Monitor risk exposure and revise strategies as appropriaten All identified risk exposure are monitored and reported on a regular basisn If a risk exposure exceeds its approved limit, corrective actions are taken
to reduce the risk exposuren Monitoring current financial status and possible short-term outcomes is
very helpful in managing pension riskn Operating within a dynamic environment
w Risk tolerances and financial objective change – existing strategies may no longer be appropriate
w Strategies need to be periodically reviewed and modifiedw Formal documentation of communication process is particularly important
Fundamental stepsFundamental steps
Steps of ALM ProcessSteps of ALM Process
1919Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 7SECTION 7
Understanding Simple ModelUnderstanding Simple Model
ExampleExample
2020Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 7 SECTION 7 (continued)
Understanding Simple ModelUnderstanding Simple Model
IRR and standard deviationIRR and standard deviation
2121Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 7 SECTION 7 (continued)
Understanding Simple ModelUnderstanding Simple Model
IRR and standard deviationIRR and standard deviation
2222Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 7 SECTION 7 (continued)
Understanding Simple ModelUnderstanding Simple Model
SolventSolvent
2323Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 7 SECTION 7 (continued)
Understanding Simple ModelUnderstanding Simple Model
SolventSolvent
2525Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u Price of Bond =n Coupon x Annuity Factor (r, T) + Par Value x PV Factor (r, T)n Annuity Factor (r, T) = {(1 – V^T) / r}n PV Factor = V^T = (1+ r) -̂T
u For example, an 8% coupon, 30-year maturity bond with par value of 1,000 paying 30 annual couponsn T = 30n Coupon = 80n r = 8% per annum – interest rate = coupon rate
Bond pricingBond pricing
Basic MetricsBasic Metrics
2626Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u Value of bondn 80 x Annuity Factor (8%, 30) + 1,000 x PV Factor (8%, 30)n 80 x 11.25778334 + 1,000 x 0.099377333n 900.6226672 + 99.37733254n 1,000
u In this example, the coupon rate equal to the market interest rate and the bond price equals par value
u If the interest rate were not equal to the bond’s coupon rate, the bond would not sell at par value
Bond pricingBond pricing
Basic MetricsBasic Metrics
2727Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u For example, if the interest rate were to rise to 10% per annum, the bond’s price would fall by 188.54 to 811.46n 80 x Annuity Factor (10%, 30) + 1,000 x PV Factor (10%, 30)n 80 x 9.426924467 + 1,000 x 0.057308553n 754.1539574 + 57.30855300n 811.46…
u At a higher interest rate, the present value of the payments to be received by the bond-holder is lowern Bond price will fall as market interest rates risen This is crucial general rule in bond valuation
Bond pricingBond pricing
Basic MetricsBasic Metrics
2828Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
Bond pricing: more examplesBond pricing: more examples
Basic MetricsBasic Metrics
2929Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
Maturity model: more examplesMaturity model: more examples
Basic MetricsBasic Metrics
3030Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u Duration is a key concept in fixed-income portfolio management for at least 3 reasonsn It is a simple summary statistic of the effective average maturity of the
portfolion It turns out to be an essential tool in immunizing portfolios from interest
rate riskn It is a measure of the interest rate sensitivity of a portfolio
u Because the relationship between maturity and the interest rate,the longer the term to maturity on a fixed income investment, the more sensitive is the value of that investment to any interest rate change, keeping everything else constant
DurationDuration
Basic MetricsBasic Metrics
3131Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u It computes the present value weighted (discounted with interest) average time to maturity of the cash flows of a certain financial instrument
u Duration method is more appropriate than a maturity method to measure interest rate risk because it not only takes into account the maturity but also the timing of the cash flows of the instrument or portfolio exposed to interest rate riskn It measures the “average life” of the asset or liability
MacaulayMacaulay’’s durations duration
Basic MetricsBasic Metrics
3232Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
MacaulayMacaulay’’s durations duration
Basic MetricsBasic Metrics
3333Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u Modified duration of financial instruments is a measure of pricesensitivity of a fixed set of cash flows to small changes in the single interest rate
u This statistic captures how small changes in the interest rate will affect changes in the price and is expressed as a percentage
u It is equal to Macaulay’s duration divided by one plus its effective annual yield to maturity
Modified durationModified duration
Basic MetricsBasic Metrics
3434Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u An insurance company issues a guaranteed investment contractn Contract for 10,000n Has a 5-year maturityn Guaranteed interest rate of 8%
u Obligation of insurance isn 10,000 x (1.08) ^ 5n 14,693.28 in 5 years
u Suppose the insurance company funds its obligation with 10,000 of 8% annual coupon bonds, selling at par value with 6 years to maturity
Example of insurance contractExample of insurance contract
Basic MetricsBasic Metrics
3535Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u As long as the market interest rate stays at 8%, the company hasfully funded the obligation, as the present value of the obligation exactly equals to the value of the bonds
u If interest rates rise, the fund will suffer capital loss, impairing the ability to satisfy the obligation
u However, at a higher interest rate, reinvested coupons will grow at a faster rate, offsetting the capital loss
u Increases in interest rates cause capital loss but at the same time increase the rate at which reinvested income will grow
Example of insurance contractExample of insurance contract
Basic MetricsBasic Metrics
3636Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
Basic MetricsBasic Metrics
Example of insurance contractExample of insurance contract
3737Penerapan SPERIS dan SANBERRIS Dana Pensiun
SECTION 8 SECTION 8 (continued)
u When the portfolio duration is set equal to the horizon date, the accumulated value of the investment fund at the horizon date will be unaffected by interest rate fluctuations – immunization
u Immunization seeks to match interest rate sensitivities of assets and liabilities
u See example on duration mismatched
Example of insurance contractExample of insurance contract
Basic MetricsBasic Metrics