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The Actuary The magazine of the Institute & Faculty of Actuaries

Liquidity risk in life insurance

One of the most important challenges
currently facing actuaries is the
new capital assessment regime imposed by the Financial Services Authority. A feature of this regime is the requirement for firms to identify and manage their liquidity risks. Actuaries have traditionally taken a somewhat informal attitude towards liquidity risk and this relaxed approach is no longer appropriate.

What is liquidity risk?
Liquidity risk may be defined as the risk that occurs when a firm, though solvent, either does not have sufficient financial resources available to enable it to meet its obligations as they fall due, or can secure them only at excessive cost. Liquidity risk losses might arise from interest payments on borrowings to meet a shortfall, or from ‘firesale losses’ incurred from the sale of illiquid assets.

Why is it important?
Liquidity issues have been important in the US for a number of years, not least because surrender values are guaranteed and often payable within a specified period of time. This was underlined when General American Life Insurance Company went into administration in August 1999 following a credit rating downgrade. Its guaranteed surrender payment clauses were invoked and the resulting outgo was greater than the liquid assets available.
Liquidity is also becoming an important consideration in the UK. For example, the strong positive cashflow that arose from expansion in the 1980s and 1990s has in some cases become negative as portfolios mature. In addition, the experience of Equitable Life has highlighted the possibility of large discretionary outflows occurring where consumers lose confidence in a company.
While the FSA has exempted life insurers from quantitative liquidity risk requirements, liquidity risk is likely to feature in the FSA’s ARROW visits to life offices.

Liability-side risk
Most elements of policy outflow can readily be predicted, so liquid resources can be arranged to cover these. However, surrenders and transfer payments can vary considerably and pose a significant risk to a firm’s liquidity position.
For with-profits business, surrender and transfer values are typically at the discretion of the insurer. This may allow liquidity losses, such as on the realisation of assets, to be passed to the surrendering policyholder. However, the ability to pass on liquidity losses will be constrained by a company’s principles and practices of financial management (PPFM), by any guaranteed surrender options, and by practical constraints.
Even if losses cannot be passed on in full to surrendering policies, these may be chargeable to the asset shares of continuing policyholders, but again this needs to be consistent with PPFM and lower asset shares may lead to higher guarantee losses.
For non-profit conventional business, annuities cannot usually be surrendered, and most term assurances will not have a surrender value. Guaranteed bond surrenders may be a problem, but liquidity risk for other non-profit classes will usually be trivial.
For unit-linked policies, it should be possible to pass liquidity losses on to surrendering policyholders in the unit price, unless policy provisions base surrender prices on quoted market prices. A more serious problem is where assets such as property cannot easily be sold, although policy provisions that allow unit realisation to be deferred can often mitigate such liquidity problems.
Dividend payments, loan interest, and tax bills are generally predictable which allows liquidity to be arranged in advance. However, companies need to be aware of any contingent liabilities, such as contracts requiring collateral to be posted on credit downgrades, which can be a hidden source of liquidity strain.

Asset-side risk
Liquidity problems can arise with investment assets. In particular, property transactions take time to complete and have a large unit size. Problems can also arise when rebalancing portfolios using futures. For example, a life company could short equity futures and buy gilts, but the latter purchases in the cash market will result in a drain on resources that will not be immediately offset by the sale of underlying assets.
Margin calls on derivatives positions can create a number of liquidity problems. First, such calls may arise at times of market stress and when asset liquidity may be tightening. Second, the timing of the cashflows on a derivative hedging an asset may be markedly different to the timing of the cashflows of the asset being held, even if they are similar in all other respects. The industrial giant Metallgesellschaft suffered a $1.3bn loss in 1993/94 when it had difficulty meeting cash calls on a long-term hedge contract, even though in theory there were offsetting profits on the business hedged. Finally, large calls may be triggered by a credit downgrading which could have other effects, not least on surrender volumes.
Margin calls will not be a problem where a position is covered by liquid assets, although such assets may not be available to meet other demands on liquidity, and care should be taken that they are not double-counted.

Sources of liquidity
Insurers will typically hold cash in the form of bank deposits, Treasury Bills, commercial paper, and other money market instruments to meet outflows.
Listed bonds and equities can usually be sold quickly to raise cash, but the price will depend on the type of asset and the amount sold, both in absolute terms and as a proportion of the total issue. Prices are usually quoted on the basis of a certain maximum deal size, with a market-maker’s spread between the bid and offer prices of the asset. When selling more than the maximum deal size, the spread will widen and a lower price will apply. The maximum deal size and spread will vary with market conditions, and will deteriorate in a crisis such as in October 1987. So liquidity losses on realising listed securities depend not only on the amount sold, but also on quoted maximum deal sizes and spreads, which are in turn affected by market conditions.
While gilts can usually be sold with minimal impact on price, most corporate bonds tend to be thinly traded and large sales may only achieved at a significant discount.
Non-listed assets such as property, mortgages, and unquoted stocks may take months to realise. Insurers may not be able to realise assets such as subsidiaries or joint venture stakes. Premium and other debts can effectively be treated as unrealisable. Cash can be realised almost immediately on approved securities through repo operations on the money market.
Another source of liquidity is a line of credit from banks and similar institutions. However, should this expire, it may not be possible to renew a credit facility in a stress situation. Often a bank will have the right to refuse the line. Even if it doesn’t, there is a counterparty risk that a bank may refuse to honour the agreement. A line of credit may be in place from an insurer’s parent, but the liquidity crisis may have been brought about because of problems with the parent, who will then be unable to honour the line.

Liquidity stress scenarios
One of the most severe liquidity stress scenarios faced by an insurer is a mass surrender of policies owing to a loss of confidence in its financial strength. This happened to Equitable Life following the House of Lords ruling on its guaranteed annuity liabilities in 2000. The only short-term limit to an office’s cash outflow is the volume of claims it can process. Sufficient liquidity should be in place to cope with such volumes to allow enough time to invoke unit deferral clauses, to adjust surrender and market value-related scales for with profits, to initiate repo sales, to call on lines of credit, and to put in place a programme of orderly asset sales to minimise losses on realisation.
Timely recognition of such a scenario is important. Indicators include a rise in the number of surrenders notified, backlogs in the claims area and unit funds moving to a ‘bid’ basis. The accounts function would also see operating cash balances being depleted.
Other liquidity stress events include a traded endowment fund surrendering all its policies, a large pension scheme transferring out, and a failure of a premium system. On the asset side, a bank failure could deplete liquid resources as could margin calls on a large derivative position, possibly linked to a credit rating downgrade.

Risk Management Working Party
Liquidity risk management for UK life insurers is still in its infancy. The Risk Management Working Party has placed a discussion paper on liquidity risk on the profession’s website and we would encourage members to review these and provide comments.