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What Is Asset/Liability Management?
Although it has evolved over time to reflect changing circumstances in the economy and
markets, in its simplest form, asset/liability management entails managing assets and cash
inflows to satisfy various obligations. It is a form of risk management, whereby one
endeavors to mitigate or hedge the risk of failing to meet these obligations. Success in the
process may increase profitability to the organization, in addition to managing risk.
Some practitioners prefer the phrase "surplus optimization" as better to explain the need to
maximize assets available to meet increasingly complex liabilities. Alternatively, surplus is
known as net worth, or the difference between the market value of assets and the present
value of the liabilities and their relationship. The discipline is conducted from a long-term
perspective that manages risks arising from the interaction of assets and liabilities; as such, it
is more strategic than tactical.
A monthly mortgage is a common example of a liability that a consumer has to fund out of
his or her current cash inflow. Each month, the individual faces the task of having sufficient
assets to pay that mortgage. Financial institutions have similar challenges, but on a much
more complex scale. For example, a pension plan must satisfy contractually established
benefit payments to retirees, while at the same time sustain an asset base through prudent
asset allocation and risk monitoring, from which to generate these ongoing payments.
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As you can assume, the liabilities of financial institutions can be quite complex and varied.
The challenge is to understand their characteristics and structure assets in such a way as to be
able to satisfy them. This may result in an asset allocation that would appear suboptimal (if
only assets were being considered). Asset and liabilities need to be thought of as intricately
intertwined, rather than separate concepts. Here are some examples of the asset/liability
challenges of various financial institutions and individuals.
HOT DEFINITIONS
A Banking Example
As financial intermediaries between the customer and the endeavor that it is looking to fund,
banks take in deposits on which they are obligated to pay interest (liabilities) and make loans
on which they receive interest (assets). Besides loans, securities portfolios comprise the
assets of banks. Banks need to manage interest rate risk, which can lead to a mismatch of
assets and liabilities. Volatile interest rates and the abolition of Regulation Q,
Q, which capped
the rate banks could pay depositors, both had a hand in this problem.
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A banks net interest margin the difference between the rate that it pays on deposits and
the rate that it receives on its assets (loans and securities) is a function of interest rate
sensitivity and the volume and mix of assets and liabilities. To the extent that a bank borrows
short term and lends long term, it has a mismatch that it needs to address through
restructuring of assets and liabilities or using derivatives (swaps, swaptions
swaptions,, options and
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With annuities
annuities,, liability requirement entails
funding income for the duration of the annuity.
As to GICs and stable value products, they are
subject to interest rate risk, which can erode
surplus and cause assets and liabilities to be
mismatched. Liabilities of life insurers tend to be
longer duration. Accordingly, longer duration and
inflation protected assets are selected to match
those of the liability (longer maturity bonds and
real estate, equity and venture capital), although
product lines and their requirements vary.
Non-life insurers have to meet liabilities (accident claims) of a much shorter duration, due to
the typical three to five year underwriting cycle. The business cycle tends to drive the
companys need for liquidity. Interest rate risk is less of a consideration than for a life
company. Liabilities tend to be uncertain as to both value and timing. The liability structure
of such a company is a function of its product line and the claims and settlement process,
which often are a function of the so-called long tail or period between the occurrence and
claim reporting and the actual payout to the policyholder. This arises due to the fact that
commercial clients make up a far larger portion of the total property and casualty market
than they do in the life insurance business, which caters largely to individuals.
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