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.
Three quite plausible scenarios highlight the resulting risks facing your business:
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.
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.
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).
So how can your business protect against rising liquidity risk?
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.
 High Quality Liquid Assets relative to Total net cash outflows over the next 30 calendar days under stress – must be greater than 100%.