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.
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.
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, which capped the rate banks could pay depositors, both had a hand in this problem.
A bank’s 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, options and futures) to satisfy the latter.
There are of two types of insurance companies: life and non-life (property and casualty). Life insurers often have to meet a known liability with unknown timing in the form of a lump sum payout. Life insurers also offer annuities (reverse life insurance), that may be life or non-life contingent, guaranteed rate accounts (GICs) and stable value funds.
With 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 company’s 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.
The traditional defined benefit plan has to satisfy a promise to pay the benefit formula specified in the plan document of the plan sponsor. Accordingly, investment is long term in nature, with a view toward maintaining or growing the asset base and providing retirement payments. In the practice known as liability-driven investment (LDI), gauging the liability entails estimating the duration of benefit payments and their present value.
Funding a benefit plan involves matching variable rate assets with variable rate liabilities (future retirement payments based upon salary growth projections of active workers) and fixed-rate assets with fixed-rate liabilities (income payments to retirees). As portfolios and liabilities are sensitive to interest rates, strategies such as portfolio immunization and duration matching may be employed to protect them from rate fluctuations.
Institutions that make grants and are funded by gifts and investments are foundations. Endowments are long-term funds owned by non-profit organizations such as universities and hospitals; both tend to be perpetual in design. Their liability is an annual spending commitment as a percentage of the market value of assets, but may not be contractual, making them different from a defined benefit pension plan. The long-term nature of these arrangements often leads to a more aggressive investment allocation meant to outpace inflation, grow the portfolio and support and sustain a specific spending policy.
With private wealth, the nature of individuals’ liabilities may be as varied as the individuals themselves. These run the gamut from retirement planning and education funding to home purchases and unique circumstances. Taxes and risk preferences will frame the asset allocation and risk management process that determines the appropriate asset allocation to meet these liabilities. Techniques of asset/liability management can approximate those used on an institutional level that considers multi-period horizons.
Finally, non-financial corporations use asset/liability management techniques, of a sort, to hedge liquidity, foreign exchange, interest rate and commodity risk. An example of the latter would be an airline hedging its exposure to fluctuations in fuel prices.
Asset/liability management has become a complex endeavor. An understanding of internal and external factors that bear upon this aspect of risk management is critical to an appropriate solution. Prudent asset allocation accounts not only for the growth of assets, but also specifically addresses the nature of an organization’s liabilities.