Since the beginning of 2003, Länsförsäkringar Liv’s (LF’s) asset management has focused on strengthening solvency and consolidation with limited risk-taking. Stronger ratios provide the Stockholm-based life and pensions insurer with better conditions to achieve its optimum portfolio as based on asset-liability modelling (ALM) – the benchmark portfolio – with an appreciably larger equity exposure of 42.5%, allowing policyholders increased chances of satisfactory returns on their investments in the long term.
The first step involved a detailed study of the portfolio risk with particular reference to LF’s liabilities. LF used its own ALM in conjunction with the Monte Carlo technique for both assets and liabilities. The ALM revealed risk level was too high in interest-bearing assets, property and active risk and too low in equity instruments to be able to provide the best possible competitive return and match liabilities with respect to the Swedish Financial Supervisory Board and LF’s own risk policy. Thus, LF sought to reduce interest risk while increasing its equity exposure, with limited risk on the downside as both LF’s own analysis and market predictions continued to show high volatility in the equity markets. The allocation and risk management teams worked together to produce an optimum risk budget using an internally developed system.
This led to the following main measures being taken: a gradual increase in equity exposure with a reduction in the interest bearing element; implementation of share protection, and implementation of interest protection.
The rate of LF’s increase to equity exposure is the result of dynamic analysis of the relationship between portfolio risk and solvency levels. A higher anticipated return means a higher risk level. LF’s acceptable risk level comes from the established return requirements and the willingness to assume risk.
The long-term acceptable risk level was reflected in the benchmark portfolio. In purely practical terms, LF carried out a running calculation of the portfolio risk in view of current solvency levels and without the insolvency probability exceeding set limits.
In January 2003, the portfolio’s equity exposure was increased due to 3% of resources being invested in a derivatives fund, which mostly consists of derivatives on large share markets. Moreover, this fund’s exposure to the equity markets equates to 2.5 times that of actual invested assets, with limited risk on the downside. The downside risk is limited because the fund could cover a maximum of 50% in any given month. LF thereby obtained an exposure of 7.5 percentage points on the equity markets, with a maximum loss of only 3% of the total portfolio value.
In summer 2003, the equity exposure at sight was increased by a further 4%, with the progressive strengthening of the ratio allowing more room for further risk. Thus that autumn, the exposure at sight was increased by an additional 6% and LF’s balance sheet position at the beginning of 2004 meant a further 5% could be exposed to the overall equity portfolios.
In conjunction with the increase in equity exposure, LF introduced a process of continuous share protection in the form of put options on underlying indices as an overlay. The put options were purchased on cash indices after the actual portfolio was optimised to reduce tracking error between the portfolio and the basket of put options. This protection eliminates the risk of LF becoming insolvent due to an acute market downturn.
In the spring of 2003, interest protection was introduced when LF’s prediction models pointed to a sharp rise in long-term US interest rates. LF insured itself against the interest risk by means of interest swaps as overlay to avoid disrupting the management. When LF carried out stable correlations between the US and European/Swedish interest markets, the interest risk in Europe/Sweden also decreased. The reduction in the interest risk was necessary to enable the increases in the equity exposure.
LF says its focus on optimum asset management and the measures adopted as a consequence have had a positive impact in several areas. Allocation by mid-2004 at 42.5% had returned to the level of the benchmark portfolio. Portfolio consolidation has strengthened considerably since 2003, increasing by 10 percentage points, excluding a one-off reallocation. Solvency has increased significantly by seven percentage points and debt coverage is good. Furthermore, LF reported a very competitive return rate for 2003 and the first half of 2004.
Highlights and achievements
Länsförsäkringar Liv’s (LF’s) response to the sharp downturns in the equity markets between 2000 and 2002, when LF saw its equity portfolio decrease by 20%, is a carefully thought-out and implemented optimum asset management strategy that has rapidly seen the life insurance company achieve its target equity allocation of 42.5%, strengthen solvency and post highly competitive returns since the strategy was conceived in 2003.
The three-pronged approach of gradually increasing equity exposure whilst reducing interest-bearing assets, implementing share protection and introducing interest protection proved to be the combination to ensure LF was able to deal with the problem of decreased equity exposure affecting returns and solvency levels. The use of a derivatives fund allowed the equity exposure to increase 2.5 times the actual invested amount whilst keeping losses at a maximum 3% of overall value. The careful progressive use of this strategy has allowed LF to increase its equity exposure as it planned.
The use of share protection removed the risk of the insurer becoming insolvent should there be a severe downturn, whilst the interest protection process further enhances LF’s ability to reduce risk whilst increasing its equity exposure.