Financial Instruments and Markets: A Casebook

6

100-Year Liabilities at Prudential Insurance

At first glance, Carlos Arrom, Managing Director of Asset Liability & Risk Management at Prudential Insurance, saw nothing particularly unusual about the $3.6 billion bond portfolio he used to match Prudential Insurance's structured settlement liabilities. The structured settlement liabilities represented long-term payment streams that Prudential Insurance promised to pay over the following 100 years to winners of lotteries or lawsuits such as those related to tobacco. The set of structured settlement liabilities had a duration of 14.86 years, matching the duration of the bond portfolio Arrom used to collateralize the liabilities. However, the durations of the liabilities and assets became frequently and significantly mismatched, requiring more and more of Arrom's time as he repeatedly had to rebalance the assets to mirror the duration of the liabilities.

Arrom called Anne Fifick, Vice President of Asset Liability & Risk Management at Prudential Insurance, to help him investigate the problem. Could it be that the dramatically low interest rates of March 2003, driven by a sluggish economy and the start of a war with Iraq, created some aberration in the markets? Was there something unusual about this relatively newly-constructed bond portfolio that Arrom did not realize? Could there be something unique about the structured settlement liabilities that Arrom had overlooked? Arrom was certain that he and Fifick, with a combined 25 years ...