Two paradigms for the market value of liabilities

Asset/liability management (ALM) theory and practices of insurers have matured and developed from early applications to guaranteed investment contracts (GICs) to all annuity and insurance products today. An important and logical next step of inquiry is the de®nition of, and calculation procedures for, the market value of an insurance liability. Because all ALM strategies have as their goal the management of some value of assets in relation to some value of liabilities, this inquiry will provide at last a canonical basis for ALM: the management of relative market values. To set the stage for this exploration, the theory and application of pricing in a complete market are reviewed, as are the practical limitations of this theory in the real, and far from complete, ®nancial markets. The notion of an ad hoc pricing model is developed, and examples are reviewed and critiqued. These models, though imperfect compared with pricing in a complete market, bridge the gap between pricing theory and practice. The current state of the liabilities market is also discussed, and this market is seen to naturally split into a ``long' ' and a ``short' ' submarket. Of particular interest is the theoretical possibility of these markets becoming broad-based, deep and active, and the conclusions are relevant to th