What is a potential consequence for an insurance company that does not effectively manage its asset and liability durations?

When an insurance company fails to effectively manage the durations of its assets and liabilities, it becomes increasingly exposed to interest rate volatility. Duration is a measure of the sensitivity of the price of a financial asset to changes in interest rates, and it is crucial for an insurance company to align the durations of its assets (investments held) with its liabilities (future policyholder claims).

If the durations are mismatched, an increase in interest rates can lead to a decrease in the value of the company's fixed income investments (assets), while simultaneously increasing the present value of liabilities (if the liabilities are sensitive to interest rates). This exposes the company to a higher degree of risk, as it may not have sufficient assets to cover its liabilities at the time they come due. Managing this duration gap is essential in ensuring that the company can meet its obligations without incurring significant losses due to adverse movements in interest rates. Therefore, the correct answer highlights the potential consequence of exposure to interest rate volatility as a result of ineffective duration management.