interest-rate risk

Interest rates do not stand still, and almost everything an insurer or pension fund owns and owes changes value when they move. The danger that a shift in interest rates will hurt the institution — by lowering the value of its assets, raising the value of its liabilities, or both unevenly — is interest-rate risk. It is the single biggest market risk most life insurers and pension funds face, precisely because their promises stretch decades into the future where small rate moves compound into large value swings.

It bites in several ways. If rates fall, the value of long liabilities balloons (you must set aside more today to meet a fixed future promise), and the maturing money you reinvest earns less than you assumed — this is reinvestment risk. If rates rise, your existing bonds lose market value, and if you are forced to sell them early to pay claims you crystallize a loss. The deepest problem is mismatch: if your assets and liabilities have different durations, a rate change moves them by different amounts, opening or closing a gap in your surplus. A firm with assets of duration 5 backing liabilities of duration 10 is badly exposed — when rates fall, its liabilities grow twice as fast as its assets.

Why it matters: interest-rate risk is the reason the entire toolkit of this field exists — duration, convexity, immunization, cash-flow matching, hedging. The goal is rarely to bet on which way rates will go; it is to arrange assets so that whichever way rates move, the change in asset value offsets the change in liability value. A common misconception is that holding 'safe' government bonds removes interest-rate risk. It does not: a long government bond is exquisitely sensitive to rates. Safety from default and safety from rate moves are different things.