Loan advice

The nature of an institutional investor’s liabilities will dictate the general investment strategy to pursue. Depository institutions, for example, seek to generate income by the spread between the return that they earn on their assets and the cost of their funds. Life insurance companies are in the spread business. Pension funds are not in the spread business, in that they themselves do not raise funds in the market. Certain types of pension funds seek to cover the cost of pension obligations at a minimum cost to the plan sponsor. Most investment companies face no explicit costs for the funds they acquire and must satisfy no specific liability obligations, the exception being target-term trusts.
A liability is a cash outlay that must be made at a specific time to satisfy the contractual terms of an obligation. An institutional investor is concerned with both the amount and timing of liabilities, because its assets must produce the cash flow to meet any payments it has promised to make in a timely way. In fact, liabilities are classified according to the degree of certainty of their amount and timing.
The descriptions of cash outlays as either known or uncertain are undoubtedly broad. When we refer to a cash outlay as being uncertain, we do not mean that it cannot be predicted. There are some liabilities where the “law of large numbers” makes it easier to predict the timing and/or amount of cash outlays. This work is typically done by actuaries, but even actuaries have difficulty predicting natural catastrophes such as floods and earthquakes.
In our description of each type of risk category, it is important to note that, just like assets, there are risks associated with liabilities. Some of these risks are affected by the same factors that affect asset risks.
A Type I liability is one for which both the amount and timing of the liabilities are known with certainty. An example would be when an institution knows that it must pay $8 million six months from now. Banks and thrifts know the amount that they are committed to pay (principal plus interest) on the maturity date of a fixed-rate certificate of deposit (CD), assuming that the depositor does not withdraw funds prior to the maturity date. Type I liabilities, however, are not limited to depository institutions. A product sold by life insurance companies is a guaranteed investment contract, popularly referred to as a GIC. The obligation of the life insurance company under this contract is that, for a sum of money (called a premium), it will guarantee an interest rate up to some specified maturity date.