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Examples Of Asset/Liability Management

By Marc L. Ross, CFP, CPA&reg, CLU&reg

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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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futures) to satisfy the latter.

Insurance Examples
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.

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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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The Benefit Plan Example

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),
(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.
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 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.
Wealth Management
With private wealth,
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
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on an institutional level that considers multi-period horizons.

Non-Financial Corporations
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
hedging its exposure to fluctuations in fuel prices.
The Bottom Line
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 organizations liabilities.

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