Open or Closed?

Moorad Choudry provides a good description of how banks think about ALM in a new article in The Actuary, Asset/liability management: solid as a rock?.  

But he misses one very important point that to RISKVIEWS explains the difference between banks and insurer/pension plans with regard to ALM.  That difference is the title of this piece.

The bank ALM model assumes that the bank will remain Open.  Therefore, the bank always has the option to obtain the funds that are needed to pay near term liabilities.  Unless the unfortunate occurrence of a liquidity problem.  The second part of this story is that banks do not mark their banking book of assets to market.  The banking book supports their “maturity transformation” business.  By keeping from that MTM step the bank keeps its large mismatch “off the books”.  This position has been the case, according to Choudry, since the the first banks.

Insurer and Pension ALM assumes that the company/fund becomes Closed and no longer has any access to new funds.  The new idea, that is a part of IFRS accounting that an insurer will mark everything to market is entirely consistent with the assumption that the company is assumed to be Closed.

That Closed company assumption along with the approach to ALM that insurers now use crept into insurance practice in the past 40 years with application of ideas that were no more than 75 years old.  One source speaks of these ideas as Anglo-American practices.  And in the discussions of Solvency II, one of the thorny topics goes back to this assumption since the German life insurance industry tends to favor an Open company approach.

The insurance company adoption of Closed company ALM started after some insurers suddenly went into the maturity transformation business in a big way only to learn that there was a definite limit to the amount of maturity transformation that could be done by an insurer relative to the capital and operations of the insurer.  Some insurers, notably The Equitable, experienced very large losses and had their business severely disrupted.  Almost 20 years later, as if to prove the necessity of the Closed company approach, General American also experienced massive losses when most funds were withdrawn from their maturity transformation business.

Looking at the ALM topic in this manner allows one to see the real and fundamental difference between the two approaches and in a non-pejorative manner.

In one sense, the insurers seem to be much too restrictive, too risk adverse, in their approach to ALM by adopting a full Closed.  Of course, insurers are not all planning on Closing,  on going out of business.  So preparing for this risk as if they were seems like extreme over caution.

On the other hand, banks, over the centuries have been subject to numerous runs and mass failures.  The Open company approach leaves a bank subject to a large contagion risk.  Once one bank has a problem, all banks may become subject to excessive withdrawals and all but the most secure banks that had been run with an Open company approach will experience severe trouble which could lead to a cascade of failures.  That is the reason why one of the fundamental functions of the Central Banks is to provide emergency liquidity to banks that are fundamentally sound.

If insurers shifted to an Open company approach to ALM, then insurers would also be subject to the same sort of fragility as the banks.  Insurers are in a different business from banks, usually providing longer term promises that require a much higher degree of confidence in their ability to be able to fulfill those promises under extremely stressful circumstances.  If insurers were operated with the same degree of fragility as banks, it is quite possible that their business model would fail completely.

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2 Comments on “Open or Closed?”

  1. Patrick Kelliher Says:

    An excellent insight into the differences between banks and life insures though I don’t think the latter would be as vulnerable as bank under open book accounting as in the UK at least we tend I take in money on a long term basis and invest mainly in relatively liquid securities as opposed to loans. We also have substantial volumes of annuities payable for life which are essentially illiquid liabilities but these are marked to market whereas a bank with liquid liabilities like sight deposits can get away with book value, which is perhaps the clearest example of the inconsistencies between bank and insurance accounting for regulatory purposes. Perhaps the government is prepared to keep banks open but is happy to let insurers fold ?

    • riskviews Says:

      Was the difference a conscious choice? Did insurers, themselves adopt the closed company approach to ALM or was it forced upon them? I am aware of no public discussion that indicated that insurers were even aware that there was a choice.


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