Liquidity risk

[bapan]

This is related to the Q5 in Oct 2010 ST9 exam. The question was about defining 'Liquidity Risk' for the insurer and how to manage the risk.

A life insurance company sells immediate annuities. It seeks as far as possible to match its future annuity payments with receipts from a portfolio of corporate bonds and equity release mortgages. The corporate bonds are purchased with the intention of holding them to maturity.The equity release mortgages are loans taken out on residential property by the homeowners, and are written with a loan to property value ratio of 25%. These loans are repayable on death, transition to long term care, or at the request of the homeowner. Interest rolls up at the agreed interest rate until the mortgage is repaid. The eventual mortgage repayment is equal to the lower of the house value and the principal together with accrued interest, both determined as at the repayment date.

(i) Define liquidity risk as it applies to this insurance company.
(ii) Explain whether it is appropriate to hold capital to mitigate liquidity risk.
(iii) Discuss how the insurance company could investigate and manage its liquidity risk.

In the model answer, whilst it defines the Liquidity Risk correctly as short term cashflow uncertainty, I am confused on the answer given for the management of this risk.

The answer focuses on general asset-liability management related to assets and liabilities in hand? In doing so it talks about long term issues as well (like mortality/morbidity experience, inflation and others).

I always thought the one should be talking about things that can cause liquidity issues in meeting liabilities due within the next 1-2 years.

Have I got this wrong? It will be helpful if anyone can elucidate this matter.

 

[dee22]

The answer focuses on general asset-liability management related to assets and liabilities in hand? In doing so it talks about long term issues as well (like mortality/morbidity experience, inflation and others).

I always thought the one should be talking about things that can cause liquidity issues in meeting liabilities due within the next 1-2 years.

Have I got this wrong? It will be helpful if anyone can elucidate this matter.

Liquidity risk is more about holding assets other than cash, and being unable to meet liabilities as they arise as a result. I don't think you can necessarily restrict it to the next 1-2 years liability cashflows.

In this case the insurer is exposing itself to liquidity risk by investing in assets which it has no control over the time of realisation. If the annuity cashflows are higher than expected the insurer may retain a solvent balance sheet but still be unable make these payments because it's tied up its reserves in these equity release products. Therefore anything leading to uncertainty over the cashflows (e.g. mortality and inflation) needs to be considered when studying the liquidity risk associated with holding these investments.

I suppose at the time the inability to meet a future annuity payment is known, because of poor mortality experience (say), the cashflow probably will be due within the next year which might relate back to the definition you're looking at?

 

[Georgina]

I tend to agree with the reply that liquidity risk isn't a short term issue. I would think of it as having the cash available to meet liabilities as they fall due over the lifetime of product.

Say we issue an equity release product 10 years ago and based on mortality improvement assumptions at the time assume the life will die in year 10. This means in our cashflow model we would be planning on receiving the proceeds of the sale of the house this year. We would be using these proceeds to pay annuitants this year. But, if the home owner lives for 15 years then where do we find the cash to pay this year's annuitants? Hence the longevity assumptions in our cashflow model were incorrect leading to liquidity risk. In out model we should stress test longevity assumptions to ensure we are prepared for this event.

Likewise, if property prices fall we won't get the amount of cash we expect when we sell the house to pay our annuitants today or in the future.

Likewise if inflation is high then RPI or LPI linked annuity payments will be higher than expected, hence we may not have the cash to cover them if we aren't invested in indexed linked gilts, for example or if property prices don't increase in line with inflation.

I'm guessing the question is saying
- what are the asset cashflows and what are the liability cashflows
- what aspects of these cashflows are uncertain
- what assumptions are used for each set of cashflows
- what happens if these assumptions are wrong
- how do we deal with this

The other side of this is that we need to invest our annuity premiums is some type of assets which yield a decent return as our earning rate assumption impacts the annuity rate we can offer the customer. If we just invested annuity premiums in a bank account then we wouldn't be able to offer very good annuity rates compared to our competitors who were invested in corporates etc. We therefore need to balance liquidity risk with market competition. I'm not sure how you classify competition as a risk, maybe operational in terms of business risk or external-market risk?

Hope that helps
Georgina