Liquidity Risk Management for Insurers
Latest insurance sector regulatory developments with increased attention on liquidity risk management
Supervision of insurers has so far focused mainly on solvency. There has been less focus on liquidity risk, which is generally not seen as a material risk for insurers, given the characteristics of traditional (life) insurers.
The inverted production cycle, where premiums are received upfront or periodically, and claims are paid afterwards when an insured event occurs, creates a stable source of funding for insurers and actually makes them liquidity providers for financial markets. Nevertheless, there is an increased attention on liquidity risk management, both from the insurance sector itself and from standard setting bodies and supervisory authorities.
Balance sheet positions and trends
Where does this increased attention come from? Two important trends can be observed for the insurance industry, (i) a move to less liquid assets, and (ii) an increase in lapse rates. Another closely related observation is that (life) insurers have balance sheet positions that can be severely impacted by changes in financial markets. Here is some more detail on these trends:
- Move to less liquid assets
As a consequence of the current low interest environment, insurers reallocate their investment portfolios for the general account to include less liquid investments, such as unlisted equities, mortgages and loans, in their search for yield. This obviously reduces the availability of liquid instruments that can be easily turned into cash whenever needed.
- Insurance product characteristics and increasing lapse rates
With regards to the (life) insurance products, there are two observations. First, there is a trend of increasing lapse rates, which can create an instant need of cash to be able to pay out the surrender value of the insurance contract. Second, products may contain surrender options or profit-sharing features, which makes estimation of future liquidity needs less certain and dependent on the development of financial markets.
- Interest rate swap positions
Insurers, particularly those with long term liabilities – life insurers and funeral insurers, for example – hold large (receiver) interest rate swap positions to manage their interest rate risk. However, large increases of reference rates may sharply increase the liquidity needs, to fulfil their variation margins or collateral obligations.
There are two perspectives with regards to the liquidity risk position of insurers. There is, of course, the perspective of the insurance company itself, but also from a macro or systemic risk perspective. A significant upward movement of interest rates will increase the liquidity needs of (life) insurers. This potentially impacts repo markets and potentially triggers fire sales of (the less liquid) assets.
Developments in regulation
For the regulatory developments, we will focus on work done and current activities of the International Association of Insurance Supervisors (IAIS) and EIOPA. Current regulation does include liquidity risk management, but only in a limited fashion. Both institutions have devoted material effort in 2019 and activities are still ongoing in 2020:
- IAIS – Holistic framework for systemic risk
The IAIS considers liquidity risk as one of three “key potential systemic exposures” stemming among others from the aforementioned move to less liquid assets, insurance product characteristics, and derivative positions. The holistic framework for systemic risk therefore already covers liquidity risk. Nonetheless, IAIS published a draft application paper on Liquidity Risk Management for Public consultation late 2019 and published resolutions comments received in June 2020. The purpose of this application paper was to provide further guidance to supervisors in their application of liquidity risk management standards in the Insurance Core Principles (ICP) and the Common Framework for the supervision of Internationally Active Insurance Groups (ComFrame).
- EIOPA – other potential macroprudential tools and measures under consideration
In the current regulatory framework, liquidity risk is only partially covered. Insurers are required to have a risk policy which covers, among others, liquidity risk. However, this does not contain any quantitative requirements covering liquidity risk. Early 2019, the European Commission asked EIOPA for advice and to review the Solvency II Directive, including the potential introduction of new regulatory tools on macro-prudential issues and measures. Proposed tools include (1) enhancement of liquidity risk monitoring, (2) liquidity risk stress testing and (3) potential introduction of liquidity buffers, a liquidity risk management plan (LRMP) and granting national supervisory authorities the power to temporarily forbid or limit lapses in exceptional circumstances.
EIOPA will provide their technical advice to the European Commission in December 2020. This is likely to include a proposal to start using the aforementioned macro-prudential tooling in phases, in the order indicated above.
How can we help?
When it comes to liquidity risk management, we have an extensive track record in successfully consulting and supporting financial institutions. We can support insurers with:
- Developing and implementing liquidity risk management plans, including:
- Liquidity risk appetite statements
- Identification of liquidity sources and liquidity needs
- Setting liquidity risk limits
- Contingency funding plans
- Assessment of the insurers’ liquidity profile
- Development or validation of liquidity models
- Operational support for liquidity stress testing
Please contact us for more information.