Case Studies - The Problem with Duration Matching

AQS was contacted by a major domestic insurer with a structured settlement business unit. These structured settlements were modeled as very high-duration liabilities.

Adhering to conventional asset-liability management techniques, the portfolio manager attempted to match the long-duration liability with long-duration assets. Zero coupon bonds are the longest duration asset available for a given maturity.

Actuarial financial modeling determined that this business was losing a great deal of money in the early years which forced sales when sufficient cash was not available to cover liabilities. The losses exacerbated the already thin cash flow coverage forcing future sales and continued business unit losses.

AQS was presented with the problem and the task of identifying a robust solution across a range of interest rate scenarios.

Using the proprietary PALM optimization platform, AQS fed client-modeled, multi-scenario liabilities into the PALM platform along with the client’s existing portfolio using the same interest rate scenarios for each. Applying client specific constraints and reinvestment rules, PALM produced a superior present day investment portfolio blueprint as well as forward guidance as to future reinvestment.

Upon further review of the results, it was determined that the zero coupons did not produce sufficient cash flow after tax to adequately cover projected cash outflows which resulted in liquidation. PALM identified this shortfall and produced a portfolio blueprint that returned the business unit to profitability.

While duration is a relevant metric, it does not adequately define the breadth of asset liability management. Duration was developed long before the advent of personal computers and yet many portfolio managers cling to this metric as a matter of comfort. Derivations of duration like key rate duration attempt to reconcile inherent shortcomings but stifle the evolution of ALM to dynamic cash flow immunization.