Amrita Pattni and Charchit Agrawal look at the issue of liquidity risk for insurers and the provisions made in the event of a major catastrophe
Following the 2007-2008 global financial crisis, there has been a renewed focus on liquidity risk. This is particularly true for banks but this risk has not been regarded as a major issue within the insurance sector. In 2009 Lord Adair Turner, the chairman of the Financial Services Authority (FSA), stated that "insurance companies are not banks, and they differ from banks above all in the much lower importance of liquidity risks, which have played such a central role in this banking crisis". This article analyses the above statement, examining the importance of liquidity risk for insurers.
What is liquidity risk?
The FSA defines this as "the risk that 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". Simply put, a firm faces liquidity risk when, in spite of holding a higher level of assets than liabilities, these assets are 'illiquid', and not easily convertible to cash. This forces it to sell its assets at a discount to quickly raise the required cash resources. Alternatively, the firm may borrow funds, which will further require a payment of interest on the loan, therefore giving rise to the 'excessive cost'.
Banks vs insurers
The nature of liquidity risk largely differs within the two industries. The banking sector's major role in financial intermediation involves the transformation of short-term deposits into longer-term loans, such as mortgages, by lending it out to borrowers. This makes it susceptible to the risk that their creditors may demand a repayment or withdraw their funds at an uncertain time.
Additionally, the banking sector faces the risk of contagion, which is not readily observed within the insurance industry. Depositors immediately begin to withdraw their funds once the word spreads that a specific bank is in trouble. This is due to the public's inability to assess the solvency position of each individual bank. Therefore, the failure of one bank may lead to a collapse in the confidence of the entire banking system, as was observed during the 2007-2008 financial crisis.
On the contrary, insurance companies usually referred to as 'risk intermediaries' transfer the risk of a loss arising from a contingent event, from the policyholder to the insurer, in exchange for premiums. Situations where the traditional insurance sector may be a source of financial instability are unlikely. These firms are financed by premiums that are paid in advance and the claim payments are only made on the occurrence of the pre-defined insured event.
The use of leveraging to increase expected returns is generally not practiced by insurance companies, making it less vulnerable to liquidity risk during a financial market collapse. However, insurance taken out on mortgages and various credit types may expect large losses as a result of default by banks and creditors during a financial crisis, resultantly causing a strain on the insurers' balance sheets, as experienced by AIG.
Is liquidity risk an issue for general insurers?
With the exception of liability insurance, the cover is usually provided for on an annual basis. A quick look at the financial statements of non-life insurance companies suggests that a large proportion of their assets is invested in highly liquid government bonds, such as three-month treasury bills, which are suitable to match these liabilities.
The greatest threat to liquidity may occur during a catastrophe when a large number of claims are received at once or there may be prospects of a significantly large claim. For these situations, they have risk management processes in place, such as reinsurance cover and alternative risk transfer methods such as cat bonds. In some cases, the full amount is not paid for a period after the event until the losses are fully adjusted, giving additional time to liquidate the assets, avoiding a liquidity crunch in the short run. Certain lines of business are more prone to large unexpected payouts than others. For instance, AV52 insurance provides coverage for third-party liability arising from war and similar acts of terrorism in the US; this may lead to huge claims at short notice, giving rise to large payouts.
Restrictions on the types of investment are very limited for these firms. The major restriction is posed by rating agencies, where companies are penalised under their factor-based models for holding long bonds or equities.
Overall, catastrophic events are rare and general insurers largely concentrate on managing the vulnerability to such events. Thus, these firms view their exposure to liquidity risk as being a consequence of a major catastrophe and so the risk is usually contained within insurance, investment or credit risk.
What about its effect on the life sector?
The most severe liquidity stress scenario faced by life insurers is a mass surrender of policies that arise due to a loss in the confidence of the financial strength of a firm. This was experienced by life insurance company Equitable Life when it received an adverse legal ruling by the House of Lords on its guaranteed annuity liabilities in 2001. Due to this, surrenders rose sharply. In 2001, its net claims arising from surrenders and maturity rose to £6.2bn from £3bn in 2000 (1).
Liquidity risk may further arise from investing in property, futures and dealing in derivatives. Property purchases usually involve a large outflow in a single transaction. This therefore, causes temporary liquidity problems unless sufficient funds are put in place in advance. Certain policy conditions may give rise to liquidity risk. In the US, policies offered loans at a predetermined rate of interest (2). When interest rates fell, firms faced severe liquidity problems since the option to take out the loan on the policy became valuable.
Reinsurance may additionally pose a residual liquidity risk with delays in payment by the reinsurer or their default which, while classed as a credit risk event, also poses major liquidity issues for the firm.
Finally, the types of life insurance products issued by a firm will affect its liquidity risk exposure. Products that are easily surrendered, in return for a surrender value, pose a higher level of risk. The inability to control the amount and defer the payment of the surrender value increases the inherent level of liquidity risk.
With-profit contracts provide an example of such policies. Although the surrender value is set by the insurer, their ability to vary these values will be limited by the firm's principles and practices of financial management. Furthermore, the settlement cannot be deferred and requires immediate payment. The Equitable Life liquidity crisis demonstrated the implications of a mass surrender of such contracts.
Regulatory initiatives for liquidity risk management in insurance
In 2004, the FSA enforced the Individual Capital Adequacy Standards framework, which introduced risk-based capital requirements for both life and general insurance firms. Although liquidity risk constitutes the list of major risk types, insurance companies are not compelled to hold capital against it, given that they are able to demonstrate that they have an appropriate liquidity risk management framework entailing adequate mitigating actions.
More recently, under the new Solvency II regime, due to take effect in January 2013, liquidity risk is not included under Pillar 1 (3), the calculation of capital charges for quantifiable risks. This is primarily due to the lack of simple and explicit formulae to quantify this risk. Nevertheless, liquidity risk should be included in the firm's own risk and solvency assessment (ORSA), which forms part of the Pillar 2 requirements.
The European Insurance and Occupational Pensions Authority (EIOPA) (formerly known as the Committee of European Insurance and Occupational Pensions Supervisors) additionally noted that asset-liability modelling is an effective tool for reducing liquidity risk in both life and non-life insurance as it co-ordinates the cash flows on the asset and liability side of the balance sheet. However, in light of the financial crisis, EIOPA aims to reconsider whether liquidity risk is a Pillar 1 issue, and thus include a capital charge for the risk in the Standard Formula.
Overall, recent events have shown that liquidity risk is no longer a minor issue in the insurance sector, highlighting the need for these firms to have the necessary systems and controls in place to adequately manage and mitigate liquidity risk.
1 Bartlett, D. et al. Liquidity management in UK Life Insurance: A discussion paper (April 2005)
3 As per the final EU Directive; 25 November 2009
Amrita Pattni is an actuarial analyst, GC Analytics, at Guy Carpenter, and Charchit Agrawal is an associate, European Actuarial Services, at Ernst & Young LLP. The views expressed are of the authors and not necessarily of their employers