Asset Liability Management for Insurance Companies at Carlson Tata NAS Annual Conference 2023

1. ASSET LIABILITY MANAGEMENT FOR INSURANCE COMPANIES : CONCEPTS AND PRACTICES CARLSON TATA NAS ANNUAL CONFERENCE 2023 20 SEP 2023

2. Disclaimer: The views expressed in this presentation are those of the author and not neccesarily those of the employer. This presentation has been prepared for informational/educational purposes only and is intended to provide a general overview of ALM concepts and practices. It is not intended to be a comprehensive study, nor to provide professional advice or advice of any nature and should not be treated as a substitute for specific advice concerning individual circumstances. 2

3. 01 Introduction to ALM CONTENT 02 Risks Managed within ALM Liability Matching 03 04 Risk-return Optimization 05 IFRS17 Implications

4. INTRODUCTION TO ALM 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 constraints.(Society of Actuaries - ALM Principles Task Force) Focuses on relative risk, not only absolute risk. • What is ALM? • Insurance business is primarily liability-based, with assets held to meet future liability outflows There are various financial risks associated with assets backing liabilities. Mismatch in assets and liabilities lead to volatility in company profits and could trigger insolvency in extreme cases. • • • Why is it important for insurance companies? Objectives of ALM Other Strategic Purposes Liability Matching Investment Strategy Capital management (putting capital to best use) Meeting financial objectives (e.g. maximizing risk adjusted return on capital; stability in P&L) • ALM is considered in formulating investment strategies, to optimize risk vs return Ensures controlled risk-taking when trying to maximize returns • Assets need to match estimated insurance obligation characteristics To protect value of own funds (surplus assets) against changes in interest rates • • • • Governance: ALM is one of the vital functions for sustaining the financial health of insurance companies. Effective governance is key to ALM success • 4

5. COMMON RISKS MANAGED WITHIN ALM FRAMEWORK Risk of fall in surplus (asset – liability) from adverse interest rate movements. (Duration Risk) Also includes reinvestment risk. Significant for life insurance companies with long liability durations. Inadequate ALM or using only simple risk metrics is very risky Understanding multiple dimensions of interest risk exposure is key • • • • • Interest Rate Risk Risk of sale of illiquid assets at unfavourable terms to cover liability demands Crucial for Non-Life business with short liability duration due to unpredictability of claims General Insurance business with short liability duration have less interest rate risk exposure (and vice-versa) • • • Liquidity Risk Losses arising from holding assets in different currency when compared to liability exposure • Currency Risk Financial loss from default event or actual default Impact of changes in Credit spreads • • Credit Risk Price risks associated with holding equities, real estate investments, and other non- fixed income assets classes • Market price Risk 5 5

6. LIABILITY MATCHING Liability Matching Concepts Cashflow matching Sensitivity Matching Immunization • Desirable, but it may not be necessary or even possible to exactly match asset and liability cashflows. • Why? • Duration-matching to reduce interest rate risk. • Matching asset and liability sensitivity to changes in a given financial variable. E.g. interest rate Visible Risks i. Reinvestment risk: Excess asset cashflows in some years to be reinvested at unknown yields ii. Duration risk: If duration is not matched, PV of Asset cashflows unlikely move in line with PV of Liabilities. Redington’s ImmunisationTheory i. PV of Assets = PV of Liabilities ii. DMT of Assets = DMT of Liabilities iii. Convexity of Assets > Convexity of Liability Protecting Economic Suplus using ALM (Assuming perfect match) 2m <-Surplus 2m <-Surplus 2m <-Surplus PV Assets PV PV PV Assets PV Assets PV Liabilities 8m Interest rates fall Liabilities Liabilities 6m 10m Interest rates rise 10m 12m 8m After interest rate change 6 Before interest rate change After interest rate change

7. LIABILITY MATCHING – DV01 MATCHING Economic Balance Sheet Sensitivity- matching of assets and liabilities more suitable. Dv01 is a measure of interest rate sensitivity Duration-matching of assets and liabilities not meaningful if PV Asset <> PV Liabilities Redington’s approach assumes a flat yield curve. Works for parallel yield movements in yields. Fixedincome 15m PV DMT= 4.5yr DV01=20m*4.5yr/10,000 Dv01= 9000 DMT= 6yr DV01=15m*6yr/10,000 Dv01= 9000 ofliabilities 20m Other assets 15m Equity 10m NAS Published Yield Curves – Par Yields Yields rise Fixedincome 10m PV ofliabilities 15m In practice, yield movements are often non- parallel. How do we manage this? Liab. fall by same amount Fixed income falls Otherassets 15m Equity 10m DV01:DollarValueof 1 basis point (dollarvariationin a bond's value per unit change inthe yield) DV01 =(Duration x Market Value)/10,000 7

8. LIABILITY MATCHING – PARTIAL DURATION & PARTIAL DV01 MATCHING Satisfying Redington’s conditions would not be sufficient to protect against non- parallel shifts in yields To protect against non-parallel shifts in yield curve, immunize on a partial duration (key rate duration) basis. Key rate duration defines a security’s sensitivity to shifts at “key” points along the yield curve. Partial Dv01 = (Partial duration x Market Value) / 10,000 8

9. KEY POINTS & CHALLENGES Additional Points to Note!! Determine interest rate risk you want to manage E..g Accounting? Economic Balance Sheet? Regulatory Balance sheet? • Challenges Accounting matching: Ensure asset classification (IFRS9) aligns with accounting liability measurement • Conflicts between matching objectives. Choices to be made • Basis: ALM is conditional on your liability projections which are uncertain or based on expectations • Limited availability of financial market instruments to manage ALM risks • Performance: Regularly assess actual performance of assets against liabilities (or suitable liability-driven benchmarks) to measure ALM success. • Nigerian capital market not as deep and liquid (leading to volatilities and yield curve “imperfections”) • Liability benchmark: Determine as a replicating portfolio of assets mirroring characteristics of libailities • Monitoring: ALM is an ongoing process and needs regular monitoring depending on volatility of market and surplus funds available • Product design : Need to determine how to managing options and guarantees • Management: Measuring the right risk exposures is key to ALM strategy and decision-making. • 9 Risk Capital : Taking Investment risks requires holding market risk capital. •

10. RISK – RETURN OPTIMISATION To Minimize risk To be Risk-efficient •Select investments that match nature, term, currency and uncertainty of the liabilities •Select invesments that maximise overral return on assets for the amount of risk taken (subject to constraints). Optimisation is the process of ensuring portfolio is risk-efficient. • Serves to optimize asset mix, in Strategic Asset Allocation (SAA) • Portfolios on efficient frontier provide highest return for specific level of risk. • Does not immunize portfolio. Non-fixed income assets result in interest rate mismatch risk • More useful, if risk is redefined to incorporate nature of assets AND liabilities. Efficient Frontier Optimisation • Maximise portfolio yield on based on shape of risk-free yield curve. • Involves executing a partial duration immunization strategy, with specified risk limits • Simultaneously maximise yield and minimize interest rate risk exposure along the yield curve Risk-Free Rate Optimisation • Maximises credit spread for a given average credit quality without changing duration Credit Spread Optimization https://www.asiainsurancereview.com/Magazine/ReadMagazineArticle?aid=35611 10

11. IFRS17 DISCOUNT RATES • Discount rate should be market-consistent but are required to match features of liability cashflows rather than assets. • Usually no market observed prices for insurance contracts. A reference portfolio of assets which matches the projected liabilities is required to assess illiquitiy premium. • Use of a Yield curve highly recommended Reflect (il)liquidity of the insurance contracts (liabilities) Discount rate should: Be consistent with (observable) market prices of financial instruments Exclude factors that do not impact insurance contracts (credit risk) • ALM will be affected by approach used to determine discount rates • Valuation of liabilities not linked to actual asset holdings. Challenges: • Subjectivities on assets to include in reference portfolio. Top-down: Yield to maturity of reference portfolio, less credit risk Determination of illiquity risk and credit risk premiums. • Credit Risk Premium Material duration gap between actual asset portfolio and reference portfolio used Illiquidity Risk Premium Illiquidity Risk Premium Sources of ALM Mismatch Credit risk premium: As it is included in asset valuation but excluded on liability side. Illiquidity premium: ALM mismatch to the extent lidquity profile of reference portolio is very different to actual portfolio Risk Free Rate Risk Free Rate Bottom-up: Risk free Rate + Illiquidity premium, based on reference portfolio 11

12. ALM IMPLICATIONS UNDER IFRS17 - ANNUITY General Measurement Model IFRS17 Transition and ALM Implications Equity • Change in liability measurement approach and assumptions upon transition from IFRS4 to IFRS17 will affect portfolio sensitivity to interest rates CSM (Contractual Service Margin) Based on locked financial assumptions. No direct sensitivity to interest rate movements Best Estimate Liability (BEL) Risk Adjustment (RA) Sensitive to interest rates. Sensitivity might differ with BEL sensitivity Risk Adjustment (RA) • Approach taken to assess RA will impact degree of sensitivity Assets • Premium on Day 1= BEL + RA + CSM • Not impacted by changes in financial assumptions (only non-financial assumptions) Best Estimate Liabilities (BEL) CSM Sensitive to interest rates • Impact of changes in interest rates flow directly to income statement. • Volatility can be reduced where option to recognise effects in Other Comprehensive Income (OCI) is chosen. 12

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