Although it has evolved to reflect changing circumstances in the economy and markets, in its simplest form, asset/liability management involves managing assets and cash inflows to satisfy obligations. It is a form of risk management, in which the investor seeks to mitigate or hedge the risk of failing to meet these obligations. Success should increase the profitability of the organization, in addition to managing risk.
Some practitioners prefer the phrase "surplus optimization" to explain the need to maximize assets to meet increasingly complex liabilities. Alternatively, surplus is also known as net worth or the difference between the market value of assets and the present value of the liabilities and their relationship. Asset and liability management 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 pays for from current cash inflows. Each month, the mortgagor must have sufficient assets to pay their mortgage. Financial institutions have similar challenges but on a much more complex scale. For example, a pension plan must contractually satisfy established benefit payments to retirees while sustaining an asset base through prudent asset allocation and risk monitoring from which to generate these ongoing payments.
The liabilities of financial institutions are complex and varied. The challenge is to understand their characteristics and structure assets in a strategic and complementary way. This may result in an asset allocation that would appear sub-optimal (if only assets were being considered). Asset and liabilities should be thought of as intricately intertwined rather than separate concepts. Here are some examples of the asset/liability challenges of financial institutions and individuals.
The Banking Industry
As a financial intermediary between the customer and the funded endeavor, banks accept deposits for which they are obligated to pay interest (liabilities) and offer loans for which they receive interest (assets). In addition to loans, securities portfolios compose bank assets. Banks must 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 at which banks could pay depositors, contributed to 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 in the short term and lends in the long term, there is a mismatch that the bank must address by restructuring its assets and liabilities or using derivatives (e.g., swaps, swaptions, options, and futures) to satisfy its liabilities.
There are of two types of insurance companies: life and non-life (e.g., property and casualty). Life insurers also offer annuities that may be life or non-life contingent, guaranteed rate accounts (GICs), or stable value funds.
With annuities, liability requirements entail funding income for the duration of the annuity. For GICs and stable value products, they are subject to interest rate risk, which can erode a surplus and cause assets and liabilities to be mismatched. Liabilities of life insurers tend to be longer in 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 must meet liabilities (accident claims) of much shorter duration due to the typical three to five-year underwriting cycle. The business cycle tends to drive a company’s need for liquidity. Interest rate risk is less of a consideration for a non-life insurer than a life insurer. Liabilities tend to be uncertain concerning both value and timing. The liability structure of 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 because commercial clients represent a far larger portion of the total property and casualty market than in the life insurance business, which is mainly a business that caters to individuals.
The Benefit Plan
The traditionally-defined benefit plan must 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 to maintaining or growing the asset base and providing retirement payments. In the practice known as the 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 portfolios from rate fluctuations.
Foundations and Non-Profits
Institutions that make grants and are funded by gifts and investments are foundations. Endowments are long-term funds owned by non-profit organizations (e.g., universities and hospitals); they tend to be perpetual in design. Their liability is an annual spending commitment as a percentage of the market value of assets. 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 range 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 consider multi-period horizons.
Finally, non-financial corporations use asset/liability management techniques to hedge liquidity, foreign exchange, interest rates, and commodity risk. An example of the latter would be an airline hedging its exposure to fluctuations in fuel prices.
The Bottom Line
Asset/liability management is a complex endeavor. An understanding of the internal and external factors that affect risk management is critical to finding 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.