No longer the invisible risk: Why a close focus on liquidity is now critical for insurers

The financial crisis of 2008-09 might better be described as a ‘liquidity crunch’ as even well-capitalised banks were thrown into turmoil by the speed at which markets and funding dried up. 

Subsequent demands on banks are designed to ensure they have enough readily available funds to meet their obligations in times of both sudden (liquidity coverage ratio) and prolonged (net stable funding ratio) stress. There have also been major changes to the requirements on clearing and collateral. Solvency II included nothing as exacting. But now a combination of increasing surrender rates and the knock-on impact of banking reforms are forcing liquidity risk up the insurance agenda.

Liability pressures & Asset pressures
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Possible threat scenarios

Three quite plausible scenarios highlight the resulting risks facing your business:

Scenario one

Mass surrender

With interest rates low, savers are looking to funds invested in property and other alternative asset classes to help boost returns. But if there were a sudden fall in asset values, many policyholders might wish to cash-in their policies to cover income shortfalls, a move that would come at just the time funds are most exposed to liquidity strains. It’s notable that some funds imposed minimum notice periods following the EU referendum. But such actions can cause reputational damage and, in an extreme scenario, accelerate the run on the fund.

Scenario two

Transitioning assets under stress

Your contingency plans should include selling assets under stress and buying alternatives (this is required under the matching adjustment, for example). As bond markets have contracted and some of your alternative assets are inherently illiquid, your ability to shift investments may be severely curtailed and the resulting costs could spike.

Scenario three

A sudden hike in US dollar values

Imagine you hold $100 million of credit bonds hedged back to sterling and the US dollar rose by 15%. As it’s harder to repo the assets, you may need to hold sufficient cash to cover the margin call (the dollar denominated bonds can’t be used as collateral). In an extreme case, you may need to sell assets to meet your obligations, which may create other issues (e.g. cause matching tests to fail).

Managing the risk

So how can your business protect against rising liquidity risk?

  • Adapt banking metrics
    The Basel III liquidity coverage ratio  gauges resilience against a sudden drying up of liquidity.
    While adopting this metric would provide a valuable starting point for you as an insurance business, liquidity stresses may arise over longer periods (e.g. claims following a catastrophe). Defining a suitable stress event and applying the ratio in practice could also pose significant challenges, requiring a combination of detailed knowhow
  • Generalised liquidity stress testing
    One possibility is a battery of stress tests, which might include interest rate/currency movements, mass surrenders and other events. Another is reverse stress testing – gauging how severe a liquidity event your business would be able to withstand. The results would help you to hone your risk appetite and contingency plans.
  • Liquidity planning
    Matching adjustment applications require detailed plans on how liquidity risk will be monitored, managed and mitigated within designated portfolios. Using these plan as the model, an effective approach would extend the process to cover all parts of the business.

Stay alert

Liquidity risk doesn’t pose the same systemic threat to insurers as it does to banks. But it continues to mount and therefore a close focus on your vulnerabilities, their impact and how to respond is needed to ensure your business doesn’t get caught out.

 


[1] High Quality Liquid Assets relative to Total net cash outflows over the next 30 calendar days under stress – must be greater than 100%.

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