2-Financial Markets Page 39 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 39A Type II liability is one for which the amount of the cash outlay is
known, but the timing of the cash outlay is uncertain. The most obvious
example of a Type II liability is a life insurance policy. There are many
types of life insurance policies, but the most basic type provides that, for
an annual premium, a life insurance company agrees to make a specified
dollar payment to policy beneficiaries upon the death of the insured.
Naturally, the timing of the insured’s death is uncertain.
A Type III liability is one for which the timing of the cash outlay is
known, but the amount is uncertain. A 2-year, floating-rate CD for
which the interest rate resets quarterly, based on some market interest
rate, is an example.
A Type IV liability is one for which there is uncertainty as to both the
amount and the timing of the cash outlay. There are numerous insurance
products and pension obligations in this category. Probably the most
obvious examples are automobile and home insurance policies issued by
property and casualty insurance companies. When, and if, a payment will
have to be made to the policyholder is uncertain. Whenever damage is
done to an insured asset, the amount of the payment that must be made is
uncertain. The liabilities of pension plans can also be Type IV liabilities.
In defined benefit plans, retirement benefits depend on the participant’s
income for a specified number of years before retirement and the total
number of years the participant worked. This will affect the amount of
the cash outlay. The timing of the cash outlay depends on when the
employee elects to retire, and whether the employee remains with the
sponsoring plan until retirement. Moreover, both the amount and the tim-
ing will depend on how the employee elects to have payments made—
over only the employee’s life or those of the employee and spouse.Overview of Asset/liability Management
The two goals of a financial institution are (1) to earn an adequate
return on funds invested and (2) to maintain a comfortable surplus of
assets beyond liabilities. The task of managing funds of a financial insti-
tution to accomplish these goals is referred to as asset/liability manage-
ment or surplus management. This task involves a trade-off between
controlling the risk of a decline in the surplus and taking on acceptable
risks in order to earn an adequate return on the funds invested. With
respect to the risks, the manager must consider the risks of both the
assets and the liabilities.
Institutions may calculate three types of surpluses: economic, account-
ing, and regulatory. The method of valuing assets and liabilities greatly
affects the apparent health of a financial institution. Unrealistic valuation,