Hi In this chapter,Section 2.4 pg 8 states that "The liquidity risk also arises for pension schemes purchasing insurance.For eg the purchase of annuities by a pension scheme may in itself create a liquidity risk for the pension scheme". Please explain what this means exactly. Thanks in advance!
Purchasing annuities from an insurance company requires a single premium to be paid to the insurer for each pension that is being 'bought out' in this way. These premiums can be a significant amount, particularly if the purchase is done on a bulk basis, ie for a number of pensioners at the same time. The company therefore has to find a significant amount of cash to make this payment, and this can be problematic - for example, not holding enough cash and being unable to sell existing assets quickly or at an acceptable price. Hence, liquidity risk. Hope that helps.
Could you also please explain the next line 'The purchase of cover for death-in-service lump sums will, however, remove a potentially significant liquidity risk'
Hi Bhoomi A liquidity risk is the risk of not having enough liquid assets to cover outgo payments as they fall due. The higher or more uncertain (in timing) a potential outgo payment is, the higher this risk will be. Death-in-service lump sums present a significant liquidity risk as a large cash benefit needs to be paid out on death without much notice. (This risk is particularly high for small pension schemes where the death of one highly paid member could require a significant proportion of the scheme's investments to be liquidated to provide this benefit, and where experience is more volatile due to smaller numbers of member.) By contrast, the insurance premiums for a group term assurance to cover the death-in-service lump sums will be regular and predictable and relatively small (given the relatively low probability of death for those healthy and young enough to work). Once this insurance is in place, death-in-service lump sums will be paid by the insurance company, and the pension scheme would just pay the premiums. The liquidity risk (sudden large payment being required) is therefore lower when insurance is in place. (Particularly for small pension schemes.) I hope this helps.
