The stark shift in economic conditions over recent years, with runaway inflation and rising interest rates drastically altering the financial landscape, means the long-overlooked discipline of Asset Liability Management (ALM) has become the subject of renewed focus.<\/p>\n
But it is important we chart ALM\u2019s evolution over the past 25 years before we can then understand the challenges it faces today.<\/p>\n
Until the turn of the 21st<\/sup> Century, ALM had largely been the preserve of life insurance companies. They typically used vanilla, inflation-linked government bonds to hedge their longer dated liabilities, which were often inflation protected. Some pension funds attempted to hedge their liabilities using the same instruments as the life insurance firms, plus protecting their large equity exposure using equity index options. The systems, valuation methods and risk calculations did not have to be particularly sophisticated or integrated to cope with these assets.<\/p>\n Over the past two decades, ALM has undergone significant changes, becoming more integral to a broader range of financial services companies. New legislation in the UK \u2013 such as the Pensions Act 2004 and the Companies Act 2006 \u2013 required companies to put their pension funds\u2019 assets and liabilities on their balance sheets. This led to a growth in Liability Driven Investment (LDI) programmes \u2013 an approach primarily used by pension funds to manage risks.<\/p>\n On the back of these LDI programmes, a market in interest rate and inflation swaps grew. As the LDI programmes became more mature, other bespoke Over-the-Counter (OTC) Derivatives became more common. This included Limited Price Index (LPI) Inflation Swaps, Inflation Options, Repos, Total Return Swaps, Swaptions and customised Equity Index Options.<\/p>\n Whereas once they had relied heavily on those inflation-linked government bonds, life insurers increasingly adopted many of these instruments to obtain better hedges for their liabilities. There are now over \u00a32 trillion UK pension plans which have LDI hedging programmes. There is also a significant LDI market in the Netherlands and a smaller one in the United States.<\/p>\n However, as the ALM programmes and instruments being used by firms have diversified, the process of managing them became exponentially more difficult.<\/p>\n A bank, insurer or pension fund may have multiple ALM systems in place to manage different asset classes. These systems often operate in a fragmented way, making it difficult to combine all assets into a single portfolio for valuation and risk analysis against liabilities\u2014a challenge that has intensified in recent years.<\/p>\n During the early years of the millennium, following the burst of the dot com bubble, market conditions were relatively benign. While there was a blip during the onset of the global financial crisis, by early 2009, conditions had calmed once again \u2013 interest rates, inflation and equity market volatility fell to historically low levels and, despite limited and fragmented systems, ALM was easy to manage.<\/p>\n This period ended in 2022. The rapid rise in inflation after the Covid-19 pandemic prompted central banks to hike interest rates from near-zero to over 5%. This, in turn, brought increased volatility into the markets underpinning the assets used in hedging liabilities in ALM.<\/p>\n So how do companies solve these ALM pain points? Encouragingly, although ALM has grown more complex throughout the 21st century\u2014especially in the past three years\u2014companies are actively developing and applying solutions to the challenges they face today.<\/p>\n Migrating fragmented systems into one, all-encompassing system is often an important first step. The likes of Aladdin and Bloomberg are examples of potential solutions that can provide a single view of ALM schemes and instruments.<\/p>\n Similarly, choosing the right PMS technology can make a significant different. If a company\u2019s existing PMS is unable to support its requirements \u2013 being unable to cope with OTC derivatives, for instance \u2013 then they may consider implementing an agile ALM solution, such as TS Imagine or Bloomberg, alongside the legacy PMS.<\/p>\n In addition to implementing suitably robust tech solutions, firms could use the valuation and risk calculation of vanilla and custom-made OTC derivatives within existing or new systems; design stress tests to manage cash flow requirements and meet regulatory requirements; and turn liabilities, be it cash flows or future guaranteed returns, into benchmarks so they can be used for asset liability modelling and rebalancing.<\/p>\n Ultimately, there has been a sea change in the ALM space in recent years. Today, the growing complexities of LDI requires a multi-faceted approach to ensure effectiveness, achieve efficiencies and meet regulatory demands \u2013 and we should expect an ever-greater focus on the discipline of ALM, and the tools underpinning it, in the coming months and years.<\/p>\n At Davies we have extensive experience of working within and for ALM asset managers and solving for these pain points. We understand and work extensively with systems used for ALM, whether as agile add-ons to existing setups or as comprehensive greenfield solutions. We would be happy to meet with asset managers, life insurance companies, and pension schemes to discuss and help solve these challenges.<\/p>\nManaging ALM becomes more difficult<\/h3>\n
Suddenly, flaws in ALM systems and processes were magnified, and over the past two-and-a-half years, firms have been grappling with a plethora of ALM challenges:<\/h4>\n
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Solving ALM\u2019s current challenges<\/h3>\n
How can Davies help?<\/h4>\n