Insurance sector shows resilience against liquidity risks

Thanks to regulators focusing their shift on liquidity risk management.

Recent pivotal developments such as the unexpected return of inflation, rapid interest rate hikes, the US regional banking crisis, new bank capital regulations, and the rise of alternative investments have heightened concerns over financial stability and liquidity risk.

These factors have reignited scrutiny within the insurance sector, particularly concerning liquidity risk management, revealed a new Geneva Association issue brief.

The International Association of Insurance Supervisors (IAIS) and the European Insurance and Occupational Pensions Authority (EIOPA) have both reported on the insurance sector’s stability in their recent publications. 

Despite minor declines in liquidity ratios, the overall stability of the sector has been maintained. Regulatory bodies globally are intensifying their focus on liquidity risk management, especially in life insurance, warranting an updated perspective on the issue.

Insurance products possess unique liquidity characteristics, such as their pre-paid nature and limited liquidity of liabilities. 

The sector’s liability-driven investment approach typically shields against liquidity risk. 

Key factors influencing liquidity risk at the product level include:

• Product Design: Whether products are designed to accumulate capital (with or without guarantees), offer pure protection, or both.
• Surrender Penalties: These significantly influence the likelihood of policy surrenders, impacting liquidity risk.

The insurance sector has shown resilience to recent stress tests like rapidly rising interest rates, thanks to robust product design, diversification, effective regulatory frameworks, and strong asset liability and liquidity risk management practices.

Insurance vs. Banking

Liquidity risk in insurance differs fundamentally from banking due to the distinct nature of liabilities in each sector. 

Whilst banks are directly exposed to short-term liquidity demands due to deposit-based funding, insurance companies engage in liability-driven investment strategies. This difference mitigates the likelihood of an insurance run and provides a natural hedge against liquidity risk. 

The near collapse of Credit Suisse and the U.S. regional banking crisis in March 2023 have reignited concerns about financial stability and liquidity risk. However, the insurance industry has managed to maintain a stable liquidity ratio, indicating strong liquidity management.

Product-specific liquidity risks

Liquidity risks in insurance are product-specific rather than structural. 

Key sources of liquidity risk in life insurance include policy surrenders, which are influenced by interest rate environments and economic conditions. 

Regulatory bodies like the UK’s Prudential Regulation Authority (PRA) and Bermuda Monetary Authority (BMA) are intensifying scrutiny on insurers' liquidity risk frameworks.

Resilience and risk management

The insurance sector has demonstrated resilience against liquidity risk through:

• Robust Liquidity Risk Management Practices: Effective asset-liability management (ALM) and diversification strategies have enabled insurers to meet liquidity demands.
• Regulatory Frameworks: Enhanced regulatory scrutiny has improved readiness for potential liquidity challenges.
• Continuous Premium Inflows: These allow insurers to act as significant investors even during economic downturns, contributing to financial stability.

Conclusion

The insurance industry has proven its robustness against liquidity risk, as evidenced by its resilience to recent interest rate hikes. 

Proper adherence to ALM principles and diversified product offerings have played critical roles in managing liquidity risk. 

Increased regulatory scrutiny, whilst necessary, should consider the sector's inherent strengths and resilience. 

Understanding the fundamentals of liquidity risk in insurance is crucial for ongoing risk management and regulatory practices.