Insurers have traditionally been viewed as having less exposure to liquidity risk than banks as a result of differences in the business model – they receive premiums upfront and pay claims later - allowing them to maintain a pool of liquid assets in most BAU activity. However, the PRA is concerned that recent developments in the market have led to a number of insurers being exposed to higher levels of liquidity risk. Such developments include:
The PRA’s consultation paper on liquidity risk management for insurers (CP4/19), released in March 2019, represents a significant enhancement to the regulator’s expectations around the ways in which insurers should assess and manage liquidity risk. The expectations apply to firms across the UK insurance industry, whatever their business model.
Liquidity risk is already an explicit consideration which firms should evidence in their compliance with the Prudent Person Principle (PPP) section of Solvency II (article 132) which requires firms “to ensure the security, quality, [and] liquidity…of the firm as a whole”. The PRA is placing more emphasis on the PPP when engaging with firms, and the degree of compliance with CP4/19 will be an important piece of evidence.
CP4/19 updates the PRA’s expectations in a number of areas related to liquidity risk, but in particular it is clear that the PRA expects all insurers to proactively assess their exposure to these developments in order to demonstrate that they understand the liquidity risks they are exposed to, and that they can manage them effectively.
CP4/19 – areas of focus
Liquidity risk management framework
While all insurance firms will already have a liquidity risk management framework to some degree, it is clear from the Consultation Paper that the PRA expects this to be more granular and precisely articulated than is currently the case for the majority of firms.
The framework should detail a specific liquidity risk management strategy and incorporate documented policies that set out how liquidity risk will be actively managed.
In particular, the PRA identifies that liquidity risk management frameworks should include:
• Details regarding the assessment and identification of liquidity risk exposures;
• Reporting lines of processes related to managing liquidity risk; and
• Management information and metrics which allow firms to clearly see their liquidity risk exposures.
Firms should also incorporate liquidity risk considerations throughout their stress and scenario testing process.
Material Sources of liquidity risk
While all insurers should assess their own sources of liquidity risk individually, CP4/19 highlights eight sources of liquidity risk across the insurance industry which all firms should consider in the liquidity risk assessments:
Specific areas of liquidity risk exposure
In addition to the broad material sources of liquidity risk noted above which should be considered by all insurers, there are also several liquidity risk exposures which some firms are exposed to. By specifically noting them in CP4/19, it suggests that the PRA believes that some firms do not consider the liquidity risk impact in sufficient depth:
• Group-specific risks – liquid assets may not always be freely transferrable around groups to meet liquidity needs, particularly in times of stress, and firms also need to consider the liquidity impact of intra-group transactions;
• Collateral upgrade transactions – repo-style arrangements to swap high quality liquid assets in exchange for higher yielding, but less-liquid assets, could lead to liquidity problems in a stress;
• Fungibility considerations – particularly where Matching Adjustment portfolios for life insurers have been established, assets will effectively become encumbered and not able to be used to meet other liabilities; and
• Unit-linked business – risks arise particularly in relation to operational costs, such as charges and processes associated with unit redemptions.
The PRA expects insurers to conduct specific liquidity risk-focused scenarios to identify potential sources of strain on liquid resources, and incorporate liquidity risk into broader stress testing. The tests should be linked to the liquidity risk appetite and assess the effects both of separate and combined impacts of a range of severe but plausible stresses on cash flows and demands on liquidity. It is clear that the quality of liquidity risk stress testing will be an area of focus for the PRA going forward.
While there is already a requirement in place for firms to ensure that they are able to meet financial obligations as they fall due, the PRA is far more detailed about the considerations that must be taken into account in sizing the buffer. This includes the range, quality and duration of assets that are kept within it, as well as the definition of “high quality” assets. Insurers should make conservative assessments of their potential outflows and inflows under periods of stress and hold an appropriate level of assets to enable liabilities to be met.
Risk monitoring and reporting
The PRA sees comprehensive reporting and MI on liquidity risk as absolutely essential –without it the boards and management of insurers cannot monitor the liquidity risks to which firms are exposed or evidence that the board-approved liquidity risk appetite is being met. Insurers should choose appropriate metrics for monitoring the business and for setting warning indicators to identify if it is approaching a period of liquidity stress.
Liquidity contingency plan
The concept of the ‘liquidity contingency plan’ was introduced as a regulatory requirement for banks following the financial crisis, but the PRA proposes this as a new requirement for insurers. It should set out the strategies for maintaining and raising liquidity at a time of liquidity strain, as well as managing cash flows. It should document the ways in which liquidity could be raised in a stress and how cash flows will be managed. The plan should be reviewed on a regular basis and key assumptions tested.
The consultation period for CP4/19 closes on 5 June 2019. While no date has been given for the release of a supervisory statement, the PRA has indicated that it would be in H2 2019 and that the expectations would come into effect immediately. We do not believe that the draft supervisory statement contained with CP4/19 will change materially as many of the principles and assessments identified in it bear similarity to the liquidity regime for banks that has been embedded for many years.
The recommendations in CP4/19 represent a significant step-up in what the regulator expects to see for liquidity risk management for all insurers, not just those which have obvious high liquidity risk exposures. Insurers should waste no time in considering the steps they would need to take in order to meet the requirements of the draft supervisory statement.