Pioneering risk model helps pass solvency test

For many years, Dutch pension fund ABP has been ahead of its peers in terms of innovation. Now, it is once again taking the lead in a new era of pension fund risk management. So for its pioneering work in developing an internal risk model, based on state-of-the-art risk modelling techniques, ABP has won the Best Public Pension Fund award. Four years ago, the imminent updating of the regulatory frameworks for Dutch pension funds and the introduction of fair, or market value, valuations for both assets and liabilities on the balance sheet, prompted ABP to develop a new best-in-class risk management tool.

ABP started on this project in 2003, concentrating on developing a state-of-the-art asset/liability risk model. And in 2005, at the same time as other pension funds in the Netherlands were starting to use the Dutch regulator's standardised solvency test, ABP introduced this internally-developed risk model. This helped the pension fund keep ahead of the pack.

In fact, ABP is striving to be one of the very first Dutch pension funds with an internally-developed risk model that is certified by the Dutch regulator for the solvency test in the financial assessment framework.

Not only is the resulting model successfully used today, it is also used for ABP's fair value risk profile and ex-ante risk management on a one-year horizon.

However, since it was first used, ABP has continued to refine the model by incorporating within it the latest academic standpoints. It has also embedded the model in its integrated financial risk policy framework. Besides risk factors such as interest rates, credit, stock, currency and inflation, the model handles illiquid asset classes such as hedge funds, private equity and infrastructure. It also embraces ABP's new investment framework, which differentiates between a liability-hedging portfolio and a risk-optimising portfolio.

The model offers the following advantages: in-depth analysis of ABP's one-year risk profile, with detailed risk measures and risk attributions; state-of-the-art econometric risk-modelling techniques; thorough sensitivity analyses; ABP-specific policy instruments in relation to investments, indexation and contributions; alignment with the long-term ALM analyses, and flexibility to include additional investment strategies and asset classes, and to evaluate adjustments in indexation or contribution policy.

The main objective of ABP's internal risk model is to determine the fund's fair value risk profile on a one-year horizon. Econometric models are used to simulate market values of assets and liabilities one year into the future. The model also caters for fluctuations in liabilities because of changes in interest rates, inflation and actuarial factors such as mortality rates.

The internal risk model adapts ABP's current indexation and contribution policy. It also contains the current rebalancing policy of the fund's investment plan. All major strategic asset classes are considered, including the alternative assets in which ABP invests.

One of the most important elements of the model is that it incorporates the latest econometric techniques for modelling risks on the one-year horizon. The time series approach creates arbitration-free scenarios and consistent term structures of interest rates. In addition, the risk analysis framework considers time-varying volatilities, correlations, fat tails and time-varying model parameters.

Using the model, historical stress-events and crash scenarios can also be applied to the current financial situation. While it is difficult to extend many other theoretical models to more asset classes, this is not the case with ABP's approach.
On top of these advantages, the model also allows realistic policy instruments to be taken into account. The risk figures are all based on the market value approach and current market conditions. For example, estimates of the solvency at risk, mismatch risk and probability of underfunding are part of the outcomes.

The success of any risk model depends on the way it is embedded and used within an organisation. ABP's internal risk model plays a central role in the fund's integral financial risk policy. The processes are themselves part of the so-called ‘in-control statement' which monitors the checks and balances of ABP's key organisational processes. The product development phase was able to touch on many different aspects of these processes, with involvement by individuals from diverse disciplines such as actuaries, investment professionals, controllers, policymakers and engineers.

At present, the model is used for risk management, steering and reporting at the macro fund level — for instance, for monitoring the risk budget of the investment mix in the allocation and rebalancing process.

The risk numbers have been included in the risk reports of ABP's central investment risk committee since 2004. Strategic decisions are also evaluated, based on this innovative one-year-orientated risk model. The overall goal is to have detailed assessments of the fair value risk profile available within the next year.

ABP's internal risk model is based on state-of-the-art risk modelling techniques, and is fully embedded in the organisational processes. The pension fund believes that this will contribute to setting ‘next practice' for longer-term risk management in real terms - the natural habitat of pension funds.

ABP's new best-in-class risk management tool has taken it ahead of the game in complying with the new Dutch regulatory framework, and changes to the valuation system. The model handles several different risk factors such as interest rates and inflation, besides illiquid asset classes such as hedge funds. One of its many advantages is that it incorporates the latest econometric techniques for modelling risks on a one-year horizon. It also allows realistic policy instruments to be taken into account. The model plays a central role in ABP's integral financial risk policy, and is part of the monitoring of the checks and balances of ABP's key organisational processes. It has also allowed ABP's central investment risk committee to evaluate strategic decisions. The fund believes that all this will help put it in the best situation possible to tackle the next stage of longer-term risk management in real terms.

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