Balance Sheet Management and Asset Allocation

For both banks and insurance companies, the primary overall objective of the company is to maximize the market value of the institution’s equity capital with a high level of assurance that the claims of depositors, creditors, and policyholders can be met.

Balance Sheet Management and Investment Considerations

An expression that captures how changes in the market value of assets, liabilities, and leverage levels affect the change in the market value of equity is:

• %∆E = %∆A(M) − %∆L(M − 1)

where:

%ΔE = percentage change in the value of equity

%ΔA = percentage change in the value of assets

%ΔL = percentage change in the value of liabilities

M = leverage multiplier, A / E

The previous equation can be tweaked slightly to assess the sensitivity of the institution’s equity capital to a unit change in the reference yield, y, of the assets (i.e., the modified duration of the equity capital). This equation is:

where:

D_E = modified duration of the institution’s equity capital

D_A = modified duration of the institution’s assets

D_L = modified duration of the institution’s liabilities

M = leverage multiplier, A / E

Δi/Δy = estimated change in yield of liabilities, i, relative to a unit change in yield of assets, y

This framework can be extended to consider the expected volatility (i.e., standard deviation) of the percentage changes in the market value of equity capital using the following formula:

where:

σE = standard deviation of percentage change in the market value of equity

σA   = standard deviation of percentage change in the value of assets

σL = standard deviation of percentage change in the value of liabilities

M = leverage multiplier, A / E

ρ_AL = correlation of percentage value changes in assets and liabilities

There are many strategies that the management of a bank or an insurance company can use to change the factors driving the volatility of shareholders’ equity. These strategies could relate to the investment portfolio assets or the nature of the liabilities created by the operations of the company.

Strategy	Impact on Factor	Impact on σE	Comments
Hold diversified fixed-income investments	Lowers σA	Falls	Diversified fixed income has a lower standard deviation than other riskier asset classes.
Hold high-quality fixed-income investments	Lowers σA	Falls	There’s a lower chance of significant loss in asset value.
Maintain similar asset and liability durations, and match asset/liability exposure to borrower and claimant options	Increases ρAL	Falls	Regulators penalize institutions with high asset/liability mismatches.
Hold common stock investments	Increases σALowers ρAL	Rises	Most regulators require reserves of 100% to be held against investments in common stock.
Derivatives transparency and collateralization	Lowers σA and σLIncreases ρAL	Falls	The more understood and protected against counterparty default the institution is, the less chance there is of unexpected losses.
Hold more liquid portfolio investments	Lowers σA	Falls
Surrender penalties for insurance contracts	Lowers σL	Falls	Penalties cushion losses when policyholders cash in after interest rates have risen.
Prepayment penalties on debt investments	Increases ρAL	Falls	Prepayments will occur in a low interest rate environment. Penalties on prepayments help offset rising liabilities in a falling rate environment.
Catastrophic insurance risk	Increases σL	Rises	Such losses are large and unpredictable and will cause regulators to demand higher reserves, investment in more liquid assets, and more robust reinsurance agreements.
Predictability of underwriting losses	Decreases σL	Falls	Total insurance liabilities are less uncertain.
Diversifying insurance business	Decreases σL	Falls	Total insurance liabilities are less uncertain.
Variable annuities	Increases ρAL	Falls	Asset investment gains and losses are passed through to policyholders due to the nature of the contract.

In the case of banks and insurers, optimal investment management simultaneously focuses on the investment portfolio and the liabilities of the business, all within the context of external economic conditions and regulatory reserve requirements. The investment manager also needs to be conscious of the factors that affect the volatility of shareholders’ equity and optimal levels of leverage as discussed previously.

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