Historically, insurers have regarded liquidity risk as a benign risk, given the nature of the business model. For example, it often takes liabilities longer to mature than it takes assets; life insurers receive upfront periodic payments; general insurers receive premiums before claims are paid; and, in general, assets are relatively liquid.
Recently, regulators have become increasingly concerned about liquidity risk management issues, such as insurance cycles where companies sell assets in a downturn and search for yield in an upturn, increased liquidity exposures through margin calls on derivatives, mass lapses where surrender penalties are low, insufficient working capital to fund critical services in a crisis and the inability to service debt due to trapped liquidity.
We surveyed some of the world’s largest insurance groups to determine their priorities and concerns. Three key themes emerged from our discussions:
- Governance, roles and responsibilities in liquidity management are not always clearly defined. Tasks are being more clearly allocated, and the definition of committees, approvals and escalation processes are being enhanced. More frequent review by senior management of cash flow projections, risk tolerances, compliance with risk limits, stress testing results, and effectiveness of contingency funding plans is being developed to establish more robust governance of liquidity risk.
- Liquidity risk management infrastructure relies heavily on spreadsheet solutions based on manual input. In the future, there will be a shift toward greater automation to improve visibility on liquidity positions. Steps also are being taken to generate comprehensive cash flow projections and establish and monitor liquidity risk tolerance, both of which will benefit from improved infrastructure.
- Stress testing, metrics and consistency need to be enhanced. As comprehensive cash flow projections, tracking cash flow mismatches and stressing cash flows across both shorter and longer time horizons are critical to help insurers effectively manage liquidity risk, there is room for development in these activities. Using stress tests to determine the level of liquid assets required to meet net cash outflow needs over multiple time horizons gives insurers a better chance of surviving a crisis in a downturn and optimizing excess liquidity in business as usual.
It is clear that strides made in improving visibility will help insurers not only survive a crisis but also improve their risk-adjusted return on capital by optimizing use of liquid assets. This report presents the findings of our survey and insights for insurers as they look to enhance their liquidity risk management framework
The evolution of liquidity risk management is likely to continue along its recent trajectory of balancing the needs of an insurer to survive a crisis with optimizing liquid assets for yield.
Those companies capable of enhancing their liquidity risk management framework will be best positioned to help their organizations manage and survive proliferating liquidity risks in a volatile market and optimize their liquid assets in business-as-usual. Their success will be underpinned by robust stress testing, transparent metrics and reporting, early escalations and overall strategic liquidity management.
The liquidity risk exposure of an insurer comprises the characteristics of the organization’s assets and liabilities, its internal structure, and market behavioral factors. Close management and careful fine-tuning of the liquidity risk framework are essential to help the firm survive in extreme stress and optimize assets without undue strain in less stressed conditions.
It is hardly surprising, therefore, that this survey reveals that insurers are considering what aspects of their firms’ liquidity risk management should be addressed to improve transparency and agility as boards and regulators require greater focus on strategic liquidity management.
