Solvency II update
CP4/19: Liquidity risk management for insurers
23 Jul 2019
Citing several recent changes in the insurance sector and the broader financial markets, especially the recent growth of investment in illiquid assets, the Prudential Regulation Authority (“PRA”) has suggested that there has been an aggregate increase in liquidity risk for insurers. In response, they issued Consultation Paper 4/19: “Liquidity risk management for insurers”, (“CP4/19”) in March this year, which called for consultation on a draft supervisory statement (“SS”).
The draft SS contains proposals that re-affirm the PRA’s expectations of liquidity risk oversight and management by insurers, whilst also clarifying some of the key drivers of material liquidity risk. The PRA expects to issue a finalised SS later this year.
A liquidity management refresher
While the consultation and its content came as no surprise to many, it served as a useful reminder of the areas that the PRA expects firms to consider as part of their liquidity risk management. Below we recap a selection of some of the key areas:
For insurers that are part of a group, liquidity risk is to be managed at both the individual entity and group-wide levels. In doing so, firms must ensure the risk management approach is consistent across the group. In addition, the PRA states that it expects an insurer that is part of a group to:
- Review the extent and conditions of existing intra-group transactions and assess the reliance of subsidiaries on these transactions to meet their liquidity needs;
- Consider the implications of centrally managed liquidity, and whether these facilities will be available during both stressed and benign conditions, taking into account any regulatory and legislative constraints that may exist; and
- Include specific group scenarios in its stress and scenario testing – these should be designed to capture group-specific risks and include consideration of group liabilities.
Collateral upgrade transactions
Where a firm acts as a lender of liquidity via a collateral upgrade transaction, the PRA requires it to:
- Have adequate systems and controls in place to value and manage collateral. This will include an independent and robust process to value collateral (and, if necessary, to challenge the borrower’s valuation).
- Ensure that collateral is individually identifiable and diverse. In the case of securitisations, firms should be able to identify the assets underlying the securitisation.
In some cases, insurers will “re-use” or “re-hypothecate” collateral. In these instances, insurers must recognise the additional risks introduced – for example from early termination or where the borrower wishes to substitute collateral.
To manage the risks posed by collateral upgrade transactions, insurers are expected to implement appropriate limits to minimise concentrations, for example by counterparty.
The PRA requires a borrower of liquidity to recognise that liquidity lent to, or collateral posted by, the borrower can decline in value under stress.
Matching Adjustment portfolios
The PRA has reminded insurers with Matching Adjustment (“MA”) portfolios that:
- MA portfolios must satisfy internal liquidity conditions, with a distinct liquidity plan for this purpose;
- Assets within MA portfolios are not available to meet liquidity needs elsewhere in the business;
- The insurer should conduct separate liquidity stress tests for the MA portfolio and the rest of the business; and
- The insurer is expected to manage the liquidity implications of a change in the MA portfolio or its assumptions. Alongside this, the insurer should consider the need to obtain eligible assets to maintain MA approval.
As with MA portfolios, the regulator reminds insurers that there can be no redirection of assets from with-profits funds to cover the liquidity risk (or indeed any risk) arising in the rest of the firm.
The reverse also remains a concern; insurers should be mindful that any support arrangements in place for with-profits funds could require it to redirect liquidity towards a with-profits fund and therefore put strain on other parts of the business.
The PRA requires an insurer with unit linked liabilities to be aware of:
- FCA rules and guidance on the management of liquidity within unit-linked funds;
- Operational costs and their impact on the liquidity risk profile;
- Short term liquidity needs and the actions available to manage these. For example, where policy documentation provides for a specified time to payment.
- The firm’s rights to apply fair value pricing adjustments, suspend fund redemptions or liquidate investments. Such rights may be limited by contractual provisions and vary between funds.
Assets of primary and secondary liquidity
A key focus of the PRA is the classification of assets in terms of liquidity, for example split by sources of “primary liquidity” (assets to meet short-term liquidity stresses) and “secondary liquidity” (assets to meet longer-term stresses). Firms need to determine the criteria any asset must satisfy in order to fit into either of these categories and hold such assets within their “liquidity buffer”.
In addition to holding liquid assets in the liquidity buffer, the PRA expects insurers to regularly test their access to the respective markets for each type of asset they hold for liquidity management purposes, and this should be done under both normal and stressed conditions.
Liquidity contingency plans
Insurers are expected to develop and maintain a liquidity contingency plan. Such a plan should lay out:
- Alternative sources of funding;
- What actions to take, when, and by whom;
- Tiered plans of action to reflect the stress levels that could be encountered; and
- How developments will be communicated to both internal and external stakeholders.
The contingency plan should be rigorously tested with simulation exercises, to ensure continued robustness and to update for any changes in the insurer’s liquidity risk profile.
The PRA’s consultation closed on 5 June, and it expects to issue a finalised SS later this year. The SS looks set to provide a useful one-stop shop for the PRA’s wide-ranging expectations of firms regarding liquidity risk management.
Insurers of all sizes will be looking to assess how closely their current procedures and policies are in line with the expectations set out by the PRA. Where any gaps are identified, firms will need to formulate plans to resolve them.
Hymans Robertson has a wealth of risk management experience. If you would like to discuss how your current liquidity risk framework compares to the expectations laid out in the consultation paper, please get in touch.