This time stumbled upon “asset-liability mismatch”, one of the problems a life insurance company may encounter under disintermediation scenario. The guy on Schweser Video CD 5 puts down his version of asset-liability mismatch: …under disintermediation “quote” mismatch arises since liability durations change more slowly than asset duration “unquote”, which he further supports with the claim that duration of assets is decreased by turning them into cash (at unfavorable market prices to make the matter even worse). Did not understand anything and had to open CFAI curriculum that explains: under disintermediation, i.e. rising i.r., asset-liabilities mismatch occurs: duration of liabilities contracts, as policyholders rush for liquidity, whereas the Company still holds long term assets. Such a mismatch when i.r. rise – longer duration assets/shorter duration liabilities – leads to further losses of a life insurance company. Cannot believe they messed up so simple concept so badly …
I never really understood disintermediation as the Schweser notes have just a short paragraph on it. I just assumed that it was either a net cash outflow or inflow due to A-LM.
The two views are not necessarily contradicting. the insurance company has assets invested at a certain duration. the liabilities might change their duration. for example, when interest rates go up, policy holders will borrow against, or colapse their policies to invest the money at a higher rate. the increased demand for loans/or the increased collapsed policies create a pressure on the insurance company- they now have to shorten the duration of their assets. but because interest rates went up their assets took a dive - that is why they the timing to cash in investments is the worst
florinpop Wrote: ------------------------------------------------------- > The two views are not necessarily contradicting. > > the insurance company has assets invested at a > certain duration. the liabilities might change > their duration. for example, when interest rates > go up, policy holders will borrow against, or > colapse their policies to invest the money at a > higher rate. > > the increased demand for loans/or the increased > collapsed policies create a pressure on the > insurance company- they now have to shorten the > duration of their assets. but because interest > rates went up their assets took a dive - that is > why they the timing to cash in investments is the > worst Florinpop, what you’re writing is perfectly right: first losses in surplus occur due to asset/liability mismatch; second, they are loosing more money due to bad timing. The name for the whole thing is disintermediation (more or less, as to be perefect, disintermediation is increase in cash outflows in periods of increasing i.r. due to increased borrowings and policy surrenders). The problem with Schweser is that they say asset duration changes faster because insurers turn their assets into cash, and they call this “asset/liability mismatch”. If this were true, the company would benefit from such a change, as market value of their liabilities would fall relative to assets. What happens is exactly to the opposit: duration of libilities shortens --> on top of necessity to sell at fallen prices they have significant pressure on the asset side of the BS. Actually, I brought up this topic because I believed that Schweser meant to help in studying complex ideas, but sometimes they seem to be able to screw up even simple ones.
I think disintermediation impact can be twofold - when schweser speaks to asset duration shortening they may be talking about how policy holders that have borrowed against the cash value of policy may be liquidating their loans in favor of now cheaper source of funding and that may be their point (but it is hardly a complete explanation!) - Further, policy holders will cancel their policies (for better fixed rates cash accumulation) - thereby shortening liability duration So I think both explanations are complimentary, work in opposite ALM directions, and true but not complete!