The changing face of liquidity risk management

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The Prudential Regulation Authority (PRA) has released its proposals (CP4/19) for “Liquidity risk management for insurers”. Over the last year, there have been discussions between the industry, the PRA and Financial Conduct Authority (FCA) around liquidity risk management, so these proposals come as no surprise. The PRA’s expectations are set out in six key areas of liquidity risk management, which we explore below. They are expected to come into effect in the latter half of 2019.

1. Liquidity risk management framework

Insurers are required to have a clearly defined risk appetite statement, owned by the board, along with prudent risk limits for material sources of liquidity risk covering the duration, types and severity of liquidity stresses they aim to survive. In particular, there is an emphasis on considering multiple tenors of risk.

There should also be a documented liquidity management strategy detailing the identification of all material sources of liquidity risk, the approach to stress testing, intra-group liquidity transferability (and its limitations) and the composition of the liquidity buffer.

2. Sources of liquidity risk

An insurer should understand the sources of liquidity risk it faces and assess proposed sources of liquidity. The PRA has provided a list of potential sources of liquidity risk that should be considered. These include liability-side and asset-side risks, concentration risks, off-balance sheet risks, such as the impact of the downgrade of the insurer’s credit rating, cross-currency risk, intra-day risk and franchise risk.

In addition, collateral upgrade and other similar transactions such as repos and reverse repos, stock lending and borrowing, synthetic transactions are highlighted for special consideration. The PRA has voiced concerns, which it expects to be addressed, about situations where the insurer is a borrower and a lender of liquidity in these trades.

Fungibility considerations particularly for Matching Adjustment (MA) and with-profits funds are also covered, as well as liquidity risks from unit linked busineses, such as those that occur through unit redemptions and switches and payments for operational errors.

3. Stress testing

Stress testing must consider a range of severe but plausible scenarios. They should be both fast moving and more sustained, individual and combined scenarios, and over different time horizons, e.g. seven, 30, 90 days and one year. Stress tests should be performed separately on MA portfolios and non-MA business, and for groups at both the entity and group level allowing for limitations in the fungibility of liquidity across the group.

Key areas that should be considered under stressed conditions include net premium income flows; additional margin and collateral requirements; reliance on committed lines of credit; policyholder behaviors; and correlations between funding markets.

4. Liquidity buffers

When determining which assets to hold as part of their liquidity buffers, insurers should consider graduated levels of buffers composed of different assets, depending on the nature and duration of the stresses they may be exposed to. The PRA has included guidance around criteria for which assets are considered “primary liquidity” and “secondary liquidity”. Insurers are also expected to regularly test access to markets for liquid assets and carefully consider reliance on repo and other secured funding arrangements.

5. Risk monitoring and reporting

Risk metrics for measuring and monitoring liquidity risk should be defined with appropriate justification for their use. These metrics should be approved by the insurer’s board. The PRA suggests the use of either a liquidity coverage ratio or excess liquidity metric to set target liquidity buffers. Both these metrics should be based on stress conditions. At a minimum, the PRA expects risk monitoring metrics, stress test results and information on the insurer’s liquidity buffer to be produced monthly for senior management.

6. Liquidity contingency plan (LCP)

A documented LCP should be maintained detailing how to recognise and respond to a liquidity stress event to preserve liquidity and make up cash-flow shortfalls in adverse scenarios. Specifically, this should include alternative sources of funding and the process around invoking such funding, as well as an assessment of the true availability of such funding in stressed conditions. Insurers should periodically test and update its LCP through simulation exercises.

Facing up to the changes

There are numerous factors exposing insurers to greater liquidity risk. They are increasing their investment in illiquid assets, a trend that is likely to continue. There is a greater use of derivatives with structural market changes reducing liquidity in some markets and other profitability impacts from the liability side.

The PRA’s proposals at least provide some clarity on their expectations for liquidity risk management by insurers. We expect that the larger insurers would tick the box in most of the six key areas, but it is unclear whether that would be the case for small or even mid-sized insurers. For them, a gap analysis and action plan may be needed to ensure the PRA’s expectations are met.


 

Dhiran Dookhi head shotDhiran Dookhi is a Director in Willis Towers Watson’s Insurance Investment Solutions group.

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