Mismatch

What Is a Mismatch?

A mismatch refers to incorrectly matching assets and liabilities. It is commonly analyzed in situations pertaining to asset and liability management. There are many scenarios that can lead to a mismatch, some having to do with interest rates, cash flows, maturity dates, and currency conversions.

The reason for a mismatch is different depending on the entity. Insurance companies, corporations, and investors, will all have different reasons as to why there is a mismatch between assets and liabilities. It is important to manage a mismatch because having liabilities outweigh assets can often lead to losses or bankruptcy.

Understanding a Mismatch

A mismatch is an important factor for consideration in various aspects of the financial industry. It involves asset and liability matching, which is vast in scope and can be utilized in numerous aspects of corporate finance, banking, insurance, and investments. The basic concept around asset and liability matching seeks to ensure that certain assets are available and growing to match with certain liabilities.

Actuaries and insurance companies are one area of the financial market known for their reliance on asset/liability management and their expertise in avoiding a mismatch. Corporations must manage any mismatch to make sure their assets are able to meet their liabilities, such as the paying down of debt. In the investment market, various theories and practices have been built around asset/liability matching for financial management efficiency.

Types of Mismatches

Mismatch in Insurance Companies

Insurance companies are significant users of asset/liability matching. These companies offer insurance products that require payment in the form of premiums for the payout of a claim when an accident occurs. In this manner, insurance companies need to manage their assets in relation to their liabilities; the liabilities being the payouts of funds for insurance claims.

Mismatch in Corporations

Corporations with assets to invest seek to utilize the return from those assets to make further investments in the business or to pay certain liabilities, such as paying down debt, or distribute the returns to shareholders.

As such, corporations may choose to match certain assets against certain liabilities for which the return on assets is available to cover the interest and principal payments on liabilities. This type of matching can become an integrated part of balance sheet management.

Mismatch in Investment Portfolios

In the investment industry, liability matching is often referred to as liability-driven investing. This type of strategy can be used in pension funds, retirement planning, or certain investment products.

In pension funds, a key aspect of liability-driven investing involves matching necessary cash outflows with steady cash inflows for investment. Overall, pensions funds often seek to invest in low-risk investments to ensure that the assets are maintained and available for distribution when required.

In financial planning, the requirements for income in retirement are also a consideration for liability-driven investing. This type of investing is less complex since it focuses on a single investor rather than investing for a group of investors. Liability matching in retirement planning centers around the amount of income an investor will need in retirement and the investment schedule required to ensure that the income is available.