Asset Liability Management (ALM)

In this chapter, the reader can learn the definition of Asset Liability Management (ALM). Then the paragraphs that follow describe how the embedded options work for an insurance undertaking. An explanation about the factors underlying the ALM models is provided (1. Amount of present and future cash flows, in terms of asset and liability; 2. Variance between asset and liabilities in terms of size and duration and 3. Effect of the rate of interest). ALM models are based on two possible alternative approaches: deterministic approach or stochastic approach. The second one needs a generation of a large number of economic scenarios. These scenarios can be of natural probability (or Real World) or risk neutral. In the first case, the scenarios are calibrated on historical economic data and reflect market volatility. In the second, the scenarios exclude any risk premium and are determined based on the assumption that there is no arbitrage. Replicating portfolios approach is a technique that provides that two available titles can be combined at any time together to constitute a portfolio that reproduces the performances of other structured securities (derivatives). Based on this concept, a passive contract can be modeled by building a portfolio consisting of an opportune combination of two securities.