Asset-liability risk

Assets are what the organization holds: bonds, stocks, cash, and hedges. Liabilities are what it has promised: policy benefits, guaranteed rates, and the options buried inside those promises. Each side has a value today. The difference is the surplus, or net economic value.

A market change reprices one side, or both. The engine in the picture is only a drawing of that meeting. It is not a software system, and it does not produce a regulatory capital number.

• Interest-rate risk: bond prices fall when yields rise, by about the duration.
• Credit risk: a wider spread marks a corporate bond down even if Treasuries did not move.
• Equity risk: a stock sleeve moves with the equity factor, not with the bond duration.
• Liquidity risk: the holding cannot be sold at the price the model used.
• Prepayment risk: borrowers pay a mortgage or a callable bond early, so the cash you expected later arrives now and must be reinvested.
• Reinvestment risk: cash that does arrive is reinvested at whatever yield is then available, which may be lower than the yield you had assumed.

Liability duration is the same kind of weighted time used on bonds, applied to the promised cash. A longer promise moves more when rates move. The cash itself can be uncertain. Policyholders may lapse or surrender, which pulls cash forward. A guaranteed rate means the organization may have to credit more than the assets are earning. Embedded options are choices the customer holds, such as the right to take the guarantee when it is valuable.

Those choices are why a liability is not a plain bond. A bond’s coupons are in the contract. A liability with a guarantee can get more expensive exactly when markets make the guarantee attractive. The insurance ALM page is the classroom version of keeping a hedge available for that uncertainty.

A parallel rise in yields can mark both bonds and long liabilities down. If the liabilities are longer, they fall by more dollars, and surplus rises. That can look like good news on the net line and still be a problem for reinvestment, or for a future need to pay a fixed rate. A parallel decline does the reverse to surplus.

Credit and equity shocks often hit the assets and leave a fixed liability alone, so the net moves one for one with the asset. The shock lab splits those lines so the net is a sum you can check, not a single unexplained number.