Financial services insights
Expert insights surrounding the financial services sector.
The COVID-19 pandemic, 2022 “LDI Crisis” and the PRA’s Business Plan 24/25 remind firms of the importance of sound liquidity risk management. Insurers need to ensure they have the understanding and tools to effectively manage their liquidity risk.
Liquidity risk has historically received limited attention from insurers. However, this is not a risk they are immune to, as recent developments like the increased investment in illiquid assets, interest rate volatility and insurance shocks (from natural catastrophes and pandemics) remind us. This can threaten insurers’ liquidity, with potentially severe consequences. Despite this, insurers continue to focus considerably more resources and attention on the management of capital and other risks. In 2019 the PRA published SS5/19 setting out requirements in relation to the management of liquidity risk.
Effective liquidity risk management requires an understanding of an insurer’s specific profile of liquidity sources/needs and the risks to which they are exposed. These exposures can be quite different from capital exposures, so a bottom-up analysis is important.
Insurers’ assets are generally quite liquid while liabilities are fairly illiquid. Despite this, certain business models and recent developments can give rise to significant liquidity risk exposures:
Correlations exist between many of these risks and need to be evaluated and modelled. For example, a major natural catastrophe could impact asset values and an insurer’s rating.
Infrastructure for monitoring liquidity risk is often an afterthought, built off existing reporting systems with limited investment.
There are many factors insurers need to consider in designing a liquidity risk management framework. The framework should be set out in a liquidity risk policy covering responsibilities, appetite and governance.
The framework should clearly state a methodology that considers all material sources and uses of liquidity, and the risks they are each exposed to. The risks should be stressed with the methodology specifying the stresses, their severity and time horizons over which liquidity is measured. Several time horizons may be needed depending on the firm’s liquidity volatility. |
Liquidity stress considerations • Factors giving rise to liquidity stresses • Stress severity (i.e. 1 in x years) and risk measure (e.g. VaR or TVaR) or defined scenarios • Correlations between stresses • Time horizons |
Appropriate metrics are needed to measure liquidity risk and can be used to set risk appetite and limits. The Liquidity Coverage Ratio (LCR) is commonly used but excess stressed liquidity may be more meaningful and can also reflect risk appetite by applying a multiple to the stressed uses. |
Liquidity metrics • Excess stressed liquidity = stressed sources – multiple1 * stressed uses • Liquidity coverage ratio = stressed sources / stressed uses 1 Multiple reflects risk appetite/limit |
Regular monitoring and reporting of liquidity is needed. This may be needed frequently e.g. if the firm’s liquidity is highly exposed to market movements or in times of heighted liquidity stresses. Accurately projecting future cashflows with the time granularity required for liquidity management may require adjustments to traditional actuarial data, processes and tools. Liquidity analysis needs to be performed at a level that reflects legal constraints on the transfer of liquidity, e.g. legal entity or fund level, consolidation has little meaning in this context without unrestricted fungibility. Stress and scenario testing is a useful tool to understand liquidity risk exposures to financial market movements and sudden insurance losses. It can also inform contingency planning. Material transactions should be assessed for their impact on liquidity metrics. Additionally, key liquidity metrics should be included in the ORSA process and report. Governance around actions to take in the event of insufficient liquidity should be clearly set out. A liquidity contingency plan should outline the potential options to improve liquidity and the priorities/situations under which the actions will be taken. |
Liquidity shocks can pose a major risk to insurers. Firms must invest time and resources to ensure they understand the liquidity risks arising from their business models, and have sufficient tools and capabilities to effectively manage these risks.
If you have any questions or simply want to discuss this topic in more detail then please contact us and a member of our insurance team will be in touch.
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