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The Actuary The magazine of the Institute & Faculty of Actuaries
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Useful tool or expensive toy?

Following the introduction of realistic reporting (for life insurers) and Individual Capital Assessments, the insurance industry has invested heavily in developing its financial modelling capability. Phrases such as ‘Monte Carlo simulation’ and ‘nested stochastic calculation’, are commonly employed by actuaries when describing their increasingly complex financial models. Over the past year, replicating portfolios have been vaunted as the latest must-have addition to an insurer’s asset liability model with an eye on the anticipated requirements under Solvency II — but are they a useful tool as part of an insurer’s ERM framework, or an expensive toy?

A replicating portfolio is a hypothetical collection of assets selected to closely match a portfolio of insurance liabilities. If the match is sufficiently close, the behaviour of the liabilities in a range of scenarios can be examined by investigating the behaviour of the replicating portfolio. The benefit to the insurer is the ease and pace with which the value of the replicating portfolio can be projected forward, relative to the portfolio of liabilities. This also applies to complex insurance groups, as replicating portfolios provide an efficient way to assess the group’s risk profile at various confidence levels, and the group’s economic capital. Therefore, replicating portfolios can significantly enhance an insurer’s risk and capital management.

In addition, representing the portfolio of liabilities as a hypothetical portfolio of assets can help to develop the business’s understanding of the guarantees and options embedded in the product design. As a result, replicating portfolios can assist with the communication of the nature of the portfolio of liabilities by establishing benchmark investment portfolios. They can, therefore, significantly enhance an insurer’s market risk management.

Two approaches
How do you select a replicating portfolio? There are two approaches — Greek-fitting and cash flow-fitting. Intuitively, Greek-fitting involves selecting a hypothetical portfolio of assets whose sensitivities match those of the portfolio of liabilities as closely as possible, while cash flow-fitting focuses on matching the cash flows — for example, where guaranteed cash flows are matched by year of maturity. While Greek-fitting is likely to capture only the short-term behaviour of the portfolio of liabilities, cash flow-fitting is more likely to be accurate over the longer term.

As a result, insurers are likely to employ the latter approach. This involves:
>> Selecting a statistic that will be used to assess the strength of fit
>> Identifying the candidate assets that may be included and any restrictions on the asset, such as no short positions
>> Executing routines to identify the optimal replicating portfolio.

The simplicity of the concept, and the fact that the systems and processes required to establish and employ replicating portfolios often complement rather than replace those currently employed, mean that the technique is being increasingly adopted. Does this sound too good to be true? A handful of European insurers are now experimenting with their use. While they are at differing stages of implementation, it is clear that they are progressing with varying levels of success. Implementation delays running into years, budgets running into millions of pounds, and models that don’t deliver, are all good reasons for being clear up-front on your objectives and on whether replicating portfolios are the best approach to adopt in meeting those objectives.

It is important to realise that, while the addition of replicating portfolio tools to an insurer’s ERM framework may enhance understanding of market risk, it does little to increase senior management’s understanding of non-market risks, and their interaction with market risks. Indeed, all too often, insurers’ scenario analyses can suffer as a result of risk and capital management becoming overly focused on the more sophisticated assessment of market risk.

Tangible progress
This reflects a more general criticism of insurers’ ERM frameworks where the focus is on the technology because the implementation of a particular system can be presented as tangible progress. The tumultuous events of the past 18 months highlight that the implementation of ever more sophisticated models will not necessarily protect insurers, particularly where these models are not well understood by senior management, and their calibration may tend to be overly optimistic in evaluating the severity and impact of stress scenarios.

Stress and scenario tests are a longstanding tool for actuaries, and replicating portfolios should be viewed as just one part of this area of risk analysis. A ‘back-to-basics’ approach would involve directly identifying scenarios that trigger a range of events that critically impact upon the business. For example, we may consider scenarios consistent with defined tolerances within the firm, such as profit warnings, dividend reductions, credit downgrades and crises refinancing, in other words, scenarios that would cause stakeholders to lose confidence in the business, in addition to those ‘killer’ scenarios that test ultimate insolvency.

Adopting such an approach means complementing risk and capital management with wide-ranging scenario analyses. The analyses will focus on the events, and importantly the scenarios that may lead to those events, rather than a stress scenario selected on the merit that it is expected to occur with a certain level of confidence. Such an approach expands upon the Financial Services Authority’s ‘reverse stress test’ requirement, in that a wider range of events is considered.

So, replicating portfolio techniques can be a useful tool facilitating improvement of management information on market risk, particularly for complex groups, where the tools can be used to gain a good overview of group-wide market risk. However, caution is required, not least because the desire to play with an expensive new toy can be to the detriment of an insurer’s wider risk and capital management.

Marcus Bowser is a senior manager in PricewaterhouseCoopers’ London actuarial practice
James Tuley is a director within the life department of PricewaterhouseCoopers’ actuarial and insurance management solutions practice