Mismatch generally refers to incorrectly or unsuitably matching assets and liabilities. It is commonly analyzed in situations pertaining to asset and liability management.
Breaking down a Mismatch
Mismatch is an important factor for consideration in various aspects of the financial industry. It involves asset and liability matching, which is vast in scope and can be utilized in numerous aspects of corporate finance, banking, insurance, and investments. The basic concept around asset and liability matching seeks to ensure that certain assets are available and growing at an expected rate of return to match with certain liabilities. Actuaries and insurance companies are one area of the financial market known for their reliance on asset/liability management and their expertise in avoiding mismatch. In the investment market, various theories and practices have been built around asset/liability matching for financial management efficiency.
Insurance companies are primary users of asset/liability matching. These companies offer insurance products that require a premium for the service of receiving a payout for a claim when an incident occurs, or a financial milestone is triggered. Thus, to appropriately manage the intake of investment assets and the reserve for potential liability payouts they must deploy sophisticated modeling strategies that integrate statistical probabilities of potential outcomes which may require large lump sum payouts to customers.
Corporations with assets to invest, seek to utilize the return from those assets to make further investments in the business, or pay certain liabilities. As such, corporations may choose to match certain assets against certain liabilities for which the return on assets is available to cover the interest or installment payments required on liabilities. This type of matching can become an integrated part of balance sheet management.
Investment Portfolios and Investing Strategies
In the investment industry, liability matching is often referred to as liability-driven investing. This type of strategy can be used in pension funds, retirement planning, or certain investment products.
In pension funds, a key aspect of liability-driven investing can involve matching necessary cash outflows with steady cash inflows for investment. Thus, one objective of liability-driven investing involves the steady monitoring of cash flows and the proportion of assets held in cash. Overall, pensions funds often seek to invest in low-risk investment to ensure that assets are maintained and available for distribution when required.
In financial planning, the requirements for income in retirement are also a consideration for liability-driven investing. This type of investing is less complex since it focuses on a single investor rather than investing for a portfolio of investors in a pension fund. Generally, liability matching in retirement planning centers around the amount of income an investor will need in retirement and the investment schedule required to ensure that the income is available.
In general, liability-driven investing is a concept that seeks to mitigate mismatching. To build any liability-driven investment portfolio, an investor must have specific liabilities for which they seek to manage investments against. Retirement is a major focus for liability-driven investing since investors seek to ensure steady income throughout their life.