Measuring the Duration of

Liabilities
Stephen P. DArcy, FCAS, MAAA, Ph.D.
University of Illinois
at Urbana-Champaign
Casualty Actuarial Society
Asset-Liability Management Session
San Diego, CA
May 20, 2002

Assumptions Underlying
Macaulay and Modified Duration
Cash flows do not change with interest rates
This does not hold for:
Collateralized Mortgage Obligations (CMOs)
Callable bonds
P-L liabilities due to inflation-interest rate correlation

Flat yield curve

Generally, yield curves are upward-sloping

Interest rates shift in parallel fashion

Short term interest rates tend to be more volatile
than longer term rates

An Improvement: Effective Duration

Effective duration:
Accommodates interest sensitive cash flows
Can be based on any term structure
Allows for non-parallel interest rate shifts

Effective duration is used to value such assets as:

Collateralized Mortgage Obligations
Callable bonds
And now property-liability insurance liabilities

Need to reflect the inflationary impact on future

loss and LAE payments of interest rate changes

A Further Refinement: Convexity

The larger the change in interest rates, the
larger the misestimate of the price change
using duration
Duration: first-order approximation
Accurate only for small changes in interest rates

Convexity: second-order approximation

Reflects the curvature of the price-yield curve

The Liabilities of PropertyLiability Insurers

Major categories of liabilities:
Loss reserves
Loss adjustment expense reserves
Unearned premium reserves

A Model for the Interest

Sensitivity of Loss Reserves
DArcy and Gorvett PCAS 2000
Divides loss reserves into fixed and
inflation sensitive portions

How to Reflect Fixed Costs?

Fixed here means that portion of damages
which, although not yet paid, will not be
impacted by future inflation
Tangible versus intangible damages
Determining when a cost is fixed could
require
Understanding the mindset of jurors
Lots and lots of data

A Possible Fixed Cost Formula

Proportion of loss reserves fixed in value as of time t:

f(t) = k + [(1 - k - m) (t / T) n]
k = portion of losses fixed at time of loss
m = portion of losses fixed at time of settlement
T = time from date of loss to date of payment
Proportion
of Ultimate
Payments
Fixed
k

m
n<1

n=1
n>1

0
Proportion of Payment Period

Fixed Cost Formula Parameters

Examples of loss costs that might go into k
Medical treatment immediately after the loss occurs
Wage loss component of an injury claim
Property damage

Examples of loss costs that might go into m

Medical evaluations performed immediately prior to
determining the settlement offer
General damages to the extent they are based on the
cost of living at the time of settlement
Loss adjustment expenses connected with settling
the claim

Loss Adjustment Expense Reserves

LAE on losses that have already occurred
Primarily future expenses
Sensitive to interest rate changes

Unearned Premium Reserves

Statutory reserve for the unexpired portion
of premiums
Economic value is the future losses on
current policies
Since these losses have not occurred yet,
they would be completely interest rate
sensitive

Approach for Measuring Interest Rate

Sensitivity of Insurance Liabilities
1. Select a term structure (interest rate) model
2. Generate multiple interest rate paths based on the
selected model
3. For each path, calculate the loss and LAE
payments that will develop
4. Determine the present value of each set of cash
flows by discounting by the relevant interest rates
5. Calculate the average present value over all
interest rate paths
6. This average is PV0

Measuring Interest Rate Sensitivity

of Insurance Liabilities (2)
7. Shock the initial instantaneous interest rate by
increasing, and decreasing, it by 100 basis points
8. Repeat steps 2-5 to determine PV+ and PV9. Calculate the effective duration based on:
Effective Duration = (PV--PV+)/(2PV0)(r)

Results of Effective Duration

Calculations
Effective duration is less than modified duration
Cash flows change
Higher interest rate higher cash flows
Lower interest rate lower cash flows

Longer term interest rates dont move as much as

short term rates with most term structure models

Illustrative Example:
Duration of Loss Reserve Liabilities
Aggregate Industry All Lines Combined
Based on steady-state operations and a 4% initial
short-term interest rate:

Macaulay Duration:
Modified Duration:

4.24
4.08

Based on CIR and interest-sensitive cash flows:

Effective Duration:

1.70

Stochastic Interest Rates

Cox-Ingersoll-Ross (CIR) term structure model
Equilibrium model
Mean-reverting, square-root diffusion process

dr a (b r ) dt
a =
r =
b=
=
dz =

r dz

speed of reversion to long-run mean

current short-term interest rate
long-run mean of short-term interest rate
volatility factor
standard Wiener process

Assumptions Underlying Illustrative

Effective Duration Calculation
Fixed Cost Parameters
k = 0.15
m = 0.10
n = 1.00

CIR Interest Rate Parameters

a = .25
r
= .04
b = .05
= .08

Impact of Inflation:
Embedded inflation rate = 2.5%
Future claim inflation = 4% + .40 x short-term interest rate

Why is Duration Important?

Corporations attempt to manage interest rate
risk by balancing the duration of assets and
liabilities

Surplus Duration
Sensitivity of an insurers surplus to changes
in interest rates
DS S = DA A - DL L
DS = (DA - DL)(A/S) + DL
where

D = duration
S = surplus
A = assets
L = liabilities

Surplus Duration and

Asset-Liability Management
To immunize surplus from interest rate risk,
set DS = 0
Then, asset duration should be:
D A = DL L / A
Thus, an accurate estimate of the duration of
liabilities is critical for ALM

Implications
Use the same approach to measure the interest
sensitivity of both assets and liabilities
A company may choose a duration mismatch
Need to determine if the compensation for
accepting interest rate risk is adequate