Tillinghast Smart Modeling™ Facilitates Better Risk Management
Real-Time Hedge Analytics Case Study
An insurer needed implemented a hedging strategy to manage its market risk exposures and used a Tillinghast Smart Modeling™ system to monitor the hedge.
What challenge did the client face?
The client had developed a hedging strategy but needed to implement a system to enable it to monitor and re-balance its hedge.
In theory, the client's traditional liability model could compute the required calculations. In practice, this was not an option since this system was designed with annual reporting cycles in mind as opposed to monitoring a daily hedging program. What was needed was a system that could produce the required results that ran over 100 times faster. The original model's slow run times ruled this out as a viable choice. The client needed a new tool to make the analysis less time-consuming and more understandable.
What solution did Towers Perrin provide?
The key to the solution was developing a highly accurate approximation of the client's liability model: a replicating portfolio — that is, a portfolio of assets, closely resembles that of the liability model under all the economic sensitivities of interest. The replicating portfolio is used instead of the liability model to derive the parameters, i.e. Greeks, required to monitor the hedging program. This process can be carried out in real-time, enabling the client to monitor its hedge without the need to run its stochastic models.
Towers Perrin faced a number of challenges during the implementation of the hedging tool. The tool needed to be robust enough to be used for up to a year and therefore had to be robust under the range of market movements that may occur during the course of that time period. The tool also had to be accurate enough to estimate small changes in liabilities due to small variations in economics while accurately calculating the Greeks needed for hedging. This led to an exhaustive testing process, so that when implemented the client had a clear understanding of the range of market conditions during which the tool could be used without recalibrating.
What were the benefits?
By using the hedge tool implemented with Tillinghast Smart Modeling™, the client is able to monitor its market risk exposure on a daily basis with a system that is accurate and reconciles to its full liabilities. The client was able to implement and monitor an active hedging program of its liabilities before the extremities of the financial turmoil at the end of 2008. The system is in ongoing use and without the need for external support from Towers Perrin.
Tillinghast Smart Modeling™ has enabled the client to accurately calculate the nature and size of the required hedge assets. In addition, the ability to access more timely and accurate results gives the client a far better understanding and quantification of its market risks, which it can use to support its own strategic decision making and to demonstrate that knowledge to regulators.
Why did the insurer choose Towers Perrin?
Towers Perrin continues to be the market leader in modeling solutions and has extensive experience in building replicating portfolios.
While Tillinghast Smart Modeling™ is based on techniques developed in the banking sector, Towers Perrin’s breadth of insurance expertise
and knowledge of liability models are invaluable when choosing the right tool for a product. Customizing an out-of-the-box replicating
portfolio tool so that it accurately models insurance liabilities requires a level of expertise and sophistication that this client clearly
recognized in Towers Perrin and Tillinghast Smart Modeling™.
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