Liquidity risk management for insurers

Managing liquidity risk in insurance companies

The business models of some UK insurers result in elevated exposure to liquidity risk. Despite this, management of liquidity risk does not receive as much attention or investment as capital and other risks.

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:

• Sources of liquidity may decrease due to reduced market values/liquidity of assets. The increased investment in illiquid assets to support returns on annuity business has led to a reduction in some insurers’ overall asset liquidity.
• Demands on liquidity can arise from the volatility of collateral related to derivative and reinsurance contracts. Derivative collateral is particularly sensitive to financial market movements, such as interest rates, as seen during the 2022 LDI Crisis.
• Sudden claims shocks, e.g. from natural catastrophes or pandemics, can result in the need to make significant payouts in a short period of time. Elevated climate change-related weather losses and the COVID-19 pandemic are recent examples.
• Mass lapses of savings products can lead to the need to sell underlying illiquid assets which may result in a liquidity stress if contractual mitigating measures are not in place.  
• Funding arrangements may not be available as assumed in a time of stress. Uncommitted facilities may not be provided and existing callable funding may be called.
• Contractual features like downgrade clauses can also give rise to less obvious liquidity risks through their impact on collateral and funding arrangements. 

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.

Considerations for insurers

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 heightened liquidity stresses. Accurately projecting future cash flows 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.

The bottom line

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.