Articles - The new risk on the block

I recently met a group of insurance risk officers and regulatory experts that included many from the banking sector. I think for years many of us have been very mindful of the fact that insurers and banks are different in some profound ways - this is best displayed in the so called “inverted production cycle” of insurers where the business receive cash up front to be paid back at some uncertain point in the future as claims. But this time the conversation got quite animated about the things banks and insurers have in common.

 By Kareline Daguer, Director, PwC

 In looking at the similarities there is a lot that insurers can learn from the banking sector experience. This can range from experience on recovery and resolvability plans, conduct issues such as affordability, treatment of vulnerable customers and finally key prudential risks that have flown under insurers’ radars until now such as liquidity.

 Early in March the Prudential Regulatory Authority issued for the first time a specific consultation paper (CP4/19) outlining its expectations on liquidity risk management for insurers. The paper is quite a comprehensive walk through key issues for insurers to consider when managing their liquidity risk. The sources of liquidity risk will vary from firm to firm in significant ways, depending on business model, products sold, investment strategies, asset allocation and the type of insurance liabilities such as with-profits / unit-linked / annuities. As a result, liquidity risk means very different things to different insurers depending on a number of variables.

 In providing draft guidance the PRA focuses on six key areas:
 1. Overall liquidity risk management framework
 2. Sources of liquidity risk
 3. Stress testing
 4. Liquidity buffers
 5. Risk monitoring and reporting, and
 6. Liquidity contingency plan.

 Insurers are expected to develop a liquidity risk management framework, including liquidity risk appetite, strategy and documented liquidity risk policies. The framework would bring together liquidity MI, stress testing results and early warning indicators measures with a view to managing both short and long term liquidity risks. Many insurers rely on their capital management frameworks to cover liquidity risks implicitly. However, the PRA notes that the focus on capital management can give insurers a fall sense of security and therefore relying on their existing capital management frameworks is not sufficient nor appropriate to ensure liquidity risk is well managed.

 Stress testing is considered a vital tool in managing liquidity risk and the PRA suggests a number of time horizons for conducting the tests as well as carrying them out over the business excluding and including the MA portfolio, stressing market wide disruptions and also modelling counterparty actions. The outcome of the stress testing exercise can inform the approach to liquidity buffers and insurers might want to put in place graduated levels of buffers, composed of different assets, depending on the nature and duration of the stresses it may potentially be exposed to. The buffers need to be tailored to the insurer’s business and the sources of liquidity risk that apply to it. The PRA distinguishes between assets of primary liquidity (cash and gilts) versus secondary liquidity (corporate bonds). Short term liquidity needs / stresses up to 90 days are expected to be covered mainly by assets of primary liquidity. The PRA also introduces the concept of high quality liquid assets with a view to use the concept on monitoring and reporting of liquidity risk, for example in developing a liquidity coverage ratio and excess liquidity metrics.

 For large life insurers this focus on liquidity risk will not come as a surprise - over the past four years many life insurers have been challenged about their approach to liquidity risk by the PRA and as a result many have sophisticated tools to manage liquidity risk.

 For medium sized life and general insurers this consultation might bring the need to prepare into sharp focus. Although this is only a consultation, it is unlikely that the final supervisory statement expected in the Autumn will be significantly different to the consultation. What is clear is that over the next few months insurers will have to make some plans to welcome the new risk in the block.


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