What is a potential consequence of mismatches in duration between the assets and liabilities of an insurance company?

A mismatch in duration between the assets and liabilities of an insurance company can lead to significant financial consequences, particularly in the context of interest rate volatility. Duration is a measure of the sensitivity of the price of an asset or liability to changes in interest rates. When there is a mismatch, where liabilities have a different duration compared to the assets, it means that changes in interest rates can affect the company's cash flows and financial position disproportionately.

If interest rates rise, the present value of liabilities will decrease if they have a longer duration than the assets, leading to an erosion of surplus since the company's financial position becomes strained. This volatility can impact the company's ability to satisfy its obligations to policyholders and could result in financial instability.

In contrast, mismatches do not typically lead to increased liquidity requirements or minimized reinvestment risks, nor do they improve the market value of net worth. Increased liquidity requirements are often a result of an immediate need for cash rather than a direct consequence of duration mismatches. Similarly, a company might face more reinvestment risk if assets and liabilities do not align well in terms of their duration, rather than minimizing this risk. Finally, mismatches generally do not improve market value, as they can create uncertainties and risks that investors generally view negatively