Managing Interest Rate Risk: ALM, Franchise Value, and Strategy

The objective of asset-liability management (ALM) is to measure and manage the degree to which the economic value of an insurer is adversely exposed to changes in interest rates. ALM is therefore a component of Enterprise Risk Management, which considers the impact of changes in other variables as well. As practiced by most insurers, ALM fails to take into account the existence of franchise value – the economic value to the firm of future renewals. Franchise value is not recognized by accounting rules, but can be a significant portion of an insurer’s total economic value, which is reflected in its market value. Incorporating franchise value into ALM is certainly essential, but it also poses a problem. For firms that have substantial franchise value, strategies that limit or minimize economic risk from changes in interest rates can create rating agency or regulatory problems, since these entities view the firm from an accounting point of view. The problem, then, is to identify a strategy that limits a firm’s exposure to interest rate risk while simultaneously limiting its exposure to accounting rules that could jeopardize its solvency or its ratings. The solution presented here lies in adopting a pricing strategy that controls the interest rate exposure of future cash flows from new business. This solution substantially extends the analysis first presented in Panning (1994).