“ALM existed long before Solvency II. Every company should manage
its liabilities and assets in such a way that it maintains a profile of risk and reward that is commensurate with the risks that it wants to take. Companies also need to monitor their profiles, to ensure that they never get too far out of line with their risk tolerance. Maybe Solvency II is driving this home to some extent, but it has always been there. It’s just what you call good management.”
To understand the effect that management’s business decisions are
having on the risks that the company takes—and the rewards that it is getting for taking those risks—the management needs to have a ‘precise’ model of their company, argues Urbach.
“Precise in the sense that the model has to be sufficiently detailed to
include sensitivities to all the relevant external events that have a material effect on the company. You also need to have a model of the significant exogenous pressures that are being exerted on your company,” he says.
“On the liability side you will have underwritten certain risks, and so
there are external events—hurricanes, tsunamis, nuclear disasters— which will expose these. Then there are the financial markets which affect both the assets you hold against those liabilities and, to some extent, the liabilities themselves. You need a model of all of this to understand how your business decisions are affecting your risk-reward profile.”
Building such a model has its challenges. Because of the fast-paced
environment in which we live the game is always changing and your model needs to take account of these pressures and be able to adapt, argues Urbach.
“This is a dynamic problem,” he says. “It’s not static—it’s not just about what happens today, but events tomorrow and the next day after that, continuously. Financial markets and economies can evolve in many different ways over time. Other external events, such as natural disasters, also manifest over time.”
The model needs to demonstrate how the interplay of all of these external
events is affecting your company, given the strategy that you have in place, which is also dynamic. This means that to get a good understanding of how your decisions are impacting your risk-reward profile you need to generate a large variety of ways in which the world could change.
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